<PAGE>
 
================================================================================
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
 
(MARK ONE)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
   ACT OF 1934
 
  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
 
                                      OR
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
   EXCHANGE ACT OF 1934
 
                        COMMISSION FILE NUMBER: 0-27696
 
                               ----------------
 
                              GENSYM CORPORATION
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 

                  DELAWARE                                       04-2932756
        (STATE OR OTHER JURISDICTION                          (I.R.S. EMPLOYER
      OF INCORPORATION OR ORGANIZATION)                     IDENTIFICATION NO.)

   125 CAMBRIDGE PARK DRIVE, CAMBRIDGE, MA                       02140-2329
  (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                       (ZIP CODE)
 
              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
 
                                (617) 547-2500
 
                               ----------------
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
 
                                     NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
 
                         COMMON STOCK, $.01 PAR VALUE
 
                               ----------------
 
  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained to
the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  As of March 10, 1998 there were 6,425,245 shares of the Registrant's Common
Stock outstanding. As of that date, the aggregate market value of the voting
stock held by non-affiliates of the Registrant was $23,995,542 based on the
last reported sale price of the Registrant's Common Stock on the Nasdaq
National Market as of the close of business on March 10, 1998.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
                                                        PART OF FORM 10-K
                  DOCUMENT                           INTO WHICH INCORPORATED
                  --------                           -----------------------
Portion of the Registrant's Proxy Statement
 for the 1998 Annual Meeting of Stockholders       Items 10, 11, 12 and 13 of 
                                                     Part III

================================================================================
<PAGE>
 
                               GENSYM CORPORATION
 
                                FORM 10-K INDEX
 
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                                  PART I.

Item 1.Business...................................................    3-15
Item 2.Properties.................................................      16
Item 3.Legal Proceedings..........................................      16
Item 4.Submission of Matters to a Vote of Security Holders........      16

                                 PART II.

Item 5.Market for the Registrant's Common Equity and Related
 Stockholder Matters..............................................      18
Item 6.Selected Financial Data....................................      19
Item 7.Management Discussion and Analysis of Financial Condition
              and Results of
              Operations..........................................   20-31
Item 7A.Qualitative and Quantitative Disclosures about Market
              Risk................................................      31
Item 8.Financial Statements and Supplementary Data................   32-45
Item 9.Changes in and Disagreements with Accountants on Accounting
              and Financial
              Disclosures.........................................      46

                                 PART III

Item 10.Directors and Executive Officers of the Registrant........      46
Item 11.Executive Compensation....................................      46
Item 12.Security Ownership of Certain Beneficial Owners and
 Management.......................................................      46
Item 13.Certain Relationships and Retained Transactions...........      46

                                  PART IV

Item 14.Exhibits, Financial Statements and Reports on Form 8-K....      47
Signatures........................................................      48
</TABLE>
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                                    PART I.
 
ITEM 1. BUSINESS
 
  Gensym Corporation ("Gensym" or the "Company") is a leading supplier of
software products and services for developing and deploying intelligent
systems that manage and improve complex, dynamic operations. Applications
built with the Company's products can be used on-line to monitor complex
operations, analyze data, detect problems and opportunities, provide advice,
make decisions, and take action in real time. These products are also used
off-line in the design, planning, and scheduling of operations. The Company's
core product, G2, and G2-based products, are sold to customers for a broad
array of applications in a wide range of industries, including manufacturing,
telecommunications, aerospace, transportation, and financial services.
 
  The Company's success in providing software to visionary partners and end-
users has resulted in a broad installed base of application specific solutions
that provide success references for the mainstream markets. In order to better
meet the buying requirements of companies in its primary target markets, the
Company underwent a major reorganization and adopted a solutions-oriented
approach in the sales and marketing organizations in 1997, which required a
retraining of the sales force and a major change in account structure. At the
same time, the Company established three strategic business units:
Manufacturing, Communications and Advanced Systems. These business units
coordinate the activities of the Company and its strategic partners to serve
mainstream customers in their respective markets.
 
INDUSTRY BACKGROUND
 
  Commercial organizations today face mounting pressures in the global
competitive environment. These pressures are driving organizations to increase
efficiency through improved productivity and better utilization of resources
to improve the quality of products and services, and respond more quickly to
customer needs. Organizations must also be more flexible in their operations
and bring new products and services to market faster. These challenges exist
in a broad range of industries, including manufacturing, telecommunications,
aerospace, transportation, financial services, and many others.
 
  As organizations have become larger and more complex, effective management
of operations has become an increasingly difficult task. The data-rich
environment resulting from the growing capabilities of computer systems and
networks and the broad availability of measurements and historical data from
local and remote sources have compounded the difficulty of this task. Data
must be analyzed and decisions and actions must be effected in a timely
manner, often in real time. Failure to optimize resources or manage operations
effectively can adversely affect quality, increase cost, or delay a product's
time to market, with a resulting deterioration of competitive position in the
marketplace.
 
  In an attempt to respond to these challenges, organizations have implemented
low level computer monitoring and process management systems, which have
limited functionality. For example, in manufacturing, computerized monitoring
systems are capable of maintaining steady surveillance of variables and
allowing operators to display trend graphs of measured values. However,
operators are typically required to monitor basic measurement information,
apply expertise to hundreds or thousands of constantly changing measurements,
diagnose unexpected behavior, make decisions, and take corrective action.
 
  These challenges are also present in the telecommunications industry.
Efficient utilization of network resources and optimum levels of quality
service for customers require constant monitoring of network conditions, rapid
diagnosis of network faults, and implementation of recovery actions.
Increasingly complex networks challenge the ability of computer monitoring
systems and their operators to cope with the changing availability of
resources and the vast amounts of network status and alarm information.
 
  In an effort to add intelligence to low level computer monitoring and
process management systems, a number of software products have been developed
which offer "point solutions" designed for specific purposes. Such point
solutions may satisfy part of the need for effective decision support and
control, but they are generally
 
                                       3
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inflexible and only address specific needs. In addition, it can be difficult
to integrate and maintain various point solution packages from different
vendors into a complete decision support and control system. When point
solutions are unavailable or inadequate, internal software development using
general purpose programming tools is a common but often lengthy and costly
alternative. The resulting programs typically have limited scalability and are
hard to update and maintain as requirements change.
 
  The Company believes that intelligent systems are required for organizations
to best manage and improve their complex, dynamic operations and thereby meet
their competitive challenges most effectively. These systems must analyze,
interpret, and act on large amounts of data by applying "knowledge" that
represents the expertise and experience of the best operational personnel
combined with analytical models constructed by engineers and business
professionals.
 
THE GENSYM SOLUTION
 
  Gensym software products allow organizations to develop and deploy
intelligent systems for superior management and improvement of their complex
operations. Gensym's products include G2, the Company's core product, and a
growing number of products based on G2. G2 is an object-oriented development
and deployment environment used to build intelligent applications. G2 allows
organizations to apply knowledge to data in order to reach conclusions,
provide advice, and take actions, often in real time. G2 can follow numerous
lines of reasoning based on this knowledge and analyze large amounts of data
and trends concurrently. G2 maintains an understanding of the behavior of
processes over time and the currency of information, both of which are
important for real-time management and optimization of operations.
 
  Application products based on G2 augment G2's broad capabilities with
additional functionality specific to such problems as fault diagnosis, process
management, process optimization, process simulation, and network management.
Such products are offered both by Gensym and Gensym's marketing partners.
 
  G2 and G2-based applications and products offer the following advantages:
 
    Knowledge as a Corporate Resource. Knowledge, once represented in G2, can
  be readily understood and reused, allowing organizations to capture
  operational knowledge and experience and transform it into a growing and
  evolving resource. This knowledge can be organized, stored, and
  incorporated within G2 applications. The combined expertise of many persons
  in an organization, accumulated over time, can provide a long-term
  corporate resource for replicating and extending intelligent decision
  support and control applications.
 
    Functionality. G2 includes many features that facilitate intelligent
  management and optimization of complex, dynamic operations. G2's reasoning
  engines can deal with large numbers of tasks concurrently in real time,
  thereby providing timely attention and response to multiple simultaneous
  problems. G2 can apply intelligent analysis to measurements to detect
  abnormal behavior before alarm limits are reached. Priorities can be
  assigned so that execution of critical tasks will not be delayed by less
  critical tasks. The Company believes that G2 extends object technology
  beyond that generally available in other products. Objects in G2 can
  correspond to physical objects in the real world, such as pieces of fixed
  equipment, production materials, or transportation vehicles. Because G2 can
  model real world objects, their physical locations and interconnections,
  their dynamic behavior, and causal and logical relationships among them,
  applications built using G2 can trace the root cause of a problem or
  anticipate the consequences of an abnormal condition.
 
    Ease of Development and Maintainability. G2 provides a development
  environment that allows more productive development of intelligent
  applications than conventional programming. Development in G2 is
  facilitated by the use of natural language rules and procedures, which are
  intuitive and require less specialized training to write than functions and
  methods in conventional programming languages such as C, C++, and Java. A
  single rule or procedure can apply to multiple measurements or situations,
  reducing the size of an application and the time needed to build it. An
  application can be constructed and tested
 
                                       4
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  incrementally, assisted by G2's built-in simulator, allowing operational
  experts to modify and validate the application before it is deployed. Using
  Gensym's Telewindows product, individuals at multiple geographic locations
  can concurrently develop an application. G2's development environment can
  provide a significant productivity advantage over conventional programming
  environments, thereby substantially reducing the cost and time to deploy
  applications.
 
    Ease of Deployment and Support. G2 provides for a seamless transition
  from development to deployment. The customer can select the computer
  platform on which to deploy G2 from a broad range of workstations and
  personal computers. Apart from external interfaces, G2 applications are
  portable and can run on a variety of computer platforms without
  modification or recompilation. Multiple users can have concurrent, shared
  access to any G2 application via Telewindows or via standard Intranet
  browsers and Gensym's G2 WebLink product. G2 also allows interactive
  support of an application while it is running, avoiding system down-time.
  Using Telewindows, this interactive support can be done remotely over a
  network, reducing maintenance expense. Gensym offers a set of modules that
  allow G2 to interface concurrently to multiple sources of real-time data
  from production systems and databases, so that G2 can integrate and respond
  to information from many sources to manage and optimize operations in real
  time.
 
    Economic Benefits. Because Gensym products are commonly applied to
  complex and often mission-critical applications, the economic benefits that
  customers derive from G2's advantages can be substantial. From a
  development perspective, increases in productivity from G2 could make the
  difference in meeting project deadlines and budgets, and may be a key
  competitive differentiator in achieving time-to-market objectives and in
  maintaining applications over time. Once deployed, G2 applications often
  result in increases in production, increases in process yields, quality
  improvements, and waste reduction. When operational problems occur, G2
  provides the intelligence for rapid problem resolution and corresponding
  application or service availability improvements. Economic benefits vary,
  but payback on investment is often achieved within the first year.
 
STRATEGY
 
  Gensym's objectives are to increase the market for intelligent systems and
extend its leadership in this market. To achieve these objectives, the Company
employs the following strategies:
 
    Extend Technological Leadership and Enhance Ease of Use. The Company
  plans to build upon its technology base by adding new features and
  functionality to its existing products and expanding its product line,
  particularly in the direction of industry standards and products to address
  common operational problems in its major markets. The Company believes that
  its leadership is primarily a result of its extensive set of advanced
  software technologies. The Company plans to continue to enhance the ease of
  use of its products by developing additional object libraries, application
  frameworks, development tools, utility components, and interfaces that
  support important object- and data-exchange standards.
 
    Focus on Key Accounts and Increase Penetration of Existing Customer
  Base. Gensym intends to continue to expand the market for intelligent
  systems by selling and delivering tools and solutions with and through
  partners to large organizations with complex operations and the potential
  for extensive application proliferation. The Company works in close
  cooperation with end-users and partners around the world in order to expand
  the features and capabilities of its products. After proving the
  effectiveness of its solutions in initial applications, Gensym and its
  partners promote proliferation of additional applications at additional
  sites within that organization and publicize those successes as references
  for new customers.
 
    Increase Worldwide Delivery Channel. The Company strives to have sales
  and support presence in geographic regions in which the Company believes
  there is significant demand for its products and services. The Company has
  adopted a plan to increase its sales force, primarily in the United States.
  Gensym has a total of 22 direct sales offices in North America, Europe,
  Africa, and Asia. In addition, the Company has established local
  distribution channels in Japan, South Africa and other international
  markets and has customer support service centers in North America and
  Europe. Gensym intends to increase sales and sales support resources
  significantly in its established offices.
 
                                       5
<PAGE>
 
    Expand Relationships with Marketing Partners. To encourage faster growth
  of the market for intelligent systems, the Company seeks to continue to
  form strategic relationships with systems integrators, value-added
  resellers, and OEMs that have experience in various targeted application
  markets and can build and install solutions using G2 and G2-based products.
  To increase partner business, the Company intends to add additional
  resources for channel business development and management.
 
    Increase Product Line Value in Target Markets. The Company has
  concentrated its sales of G2 and G2-based applications to customers in the
  manufacturing process industries including chemical, oil and gas, food and
  beverage and pharmaceuticals, and in telecommunications including aerospace
  and government. Gensym intends to penetrate these markets through the
  introduction of additional products that add functionality and knowledge
  applicable to manufacturers, communication service providers, and financial
  service providers. The Company plans to expand its relationship with its
  strategic partners to help accomplish this goal.
 
PRODUCTS
 
  Gensym sells G2 and a growing number of products used with or based on G2.
 
G2
 
  G2 is a comprehensive development and deployment environment for intelligent
management and optimization of complex, dynamic operations. G2 applies
knowledge that represents the experience of the best operations personnel,
combined with analytical models constructed by engineers and business
professionals and models derived from past performance, to real-time or model
data, in order to reach conclusions, provide advice, and take real or
simulated actions in a timely fashion. G2 can follow multiple lines of
reasoning based on this knowledge and consider multiple problems concurrently.
G2 maintains an understanding of the behavior of processes over time and the
currency of information, both of which are important for real-time management
of operations. G2 incorporates a broad array of integrated technologies that
allow application developers to implement object-oriented applications without
the need for conventional computer programming.
 
 Development Features
 
  G2 allows an application developer to express objects, rules, models and
procedures using structured natural language so that they can be readily
understood and modified. The G2 development environment allows a developer to
test an application using simulated data and to view the results graphically.
In this way, an application can be tested under various scenarios before
deployment. Rapid incremental application development can be done
interactively, to facilitate application improvements during prototyping,
during development and even while in deployment. Using G2's ability to support
rapid application development, a developer can show a dynamic, graphically
animated prototype of an application to an end-user at an early stage.
 
  Using G2, an application developer can model a process in terms of
interrelated objects, which may be in graphical or schematic diagram form.
These object-based graphical connections enable G2 to reason about the
interdependent behavior of connected process objects. G2's high-level
representation of knowledge allows persons in many positions and roles in an
organization to develop applications more quickly and easily, while aiding
maintainability and reusability. Using Gensym's Telewindows product,
developers at multiple geographic locations can work in teams to concurrently
develop applications.
 
 Deployment Features
 
  Applications built on G2 are portable and interoperable across a number of
computer platforms, so solutions can be offered on any of a wide range of
platforms and later migrated to new and more powerful computers and operating
systems. G2 currently runs on Intel PC's running Windows NT and on
workstations from Digital Equipment Corporation, Hewlett-Packard, IBM, Sun
Microsystems and others. G2 currently runs under Windows NT, as well as the
UNIX and VMS operating systems.
 
                                       6
<PAGE>
 
  G2 allows many procedures or rules to be active concurrently. A procedure or
rule can be executing, suspended to allow other computations to occur, or
waiting for a triggering event. G2 enhances the reliability of on-line
applications by its facility to save "snap-shots" of a process state and "warm
boot" to the last saved state, so that an intelligent real-time system can
resume after power failures or other interruptions. Applications can also be
modified without interrupting the running of the application.
 
  Through its G2 technology, G2 can support concurrent access to multiple
sources of data and high-performance data exchange. Once an application is
deployed, Telewindows and Gensym's G2 WebLink allows multiple users to share
that application concurrently. Telewindows and G2 WebLink are available on all
G2 platforms as well as on PC's running Windows 95.
 
 Pricing
 
  Pricing for a G2 perpetual license starts at $36,000 for on-line development
and $20,000 for the deployment version, with volume discounts to encourage
large projects and product proliferation. G2 on-line development is also
offered in a bundled starter kit that includes first year customer support,
two weeks of application consulting services and two weeks of training.
 
TELEWINDOWS AND G2 WEBLINK
 
  Telewindows operates in conjunction with G2 and enables concurrent shared
access to G2 from multiple geographic locations. Telewindows gives each member
of a development team full concurrent access to an application as a native
developer, with immediate awareness of and access to objects and other
knowledge created by other team members. Telewindows enables remote system
maintenance by allowing full developer access to on-line deployed applications
remotely across a network. Once an application is deployed, Telewindows allows
multiple users to share that application concurrently.
 
  Multiple end-users on a network can access multiple applications via
Telewindows. Each user is provided with specific capabilities and restrictions
according to the authorized level of access. For example, in typical
manufacturing operations, the process or plant operators may have access to
intelligent diagnostics and other decision support while the maintenance
group, plant management, plant engineers and others may share the knowledge
and real-time analysis appropriate to their respective tasks.
 
  In addition to Telewindows, G2 WebLink enables users to interact with G2
applications remotely from browsers like Netscape and Microsoft Explorer. This
product "web-enables" G2, that is, provides standard user access over Internet
or Intranet connections.
 
DATA INTERFACE MODULES
 
  The Company and many of its marketing partners offer specific interface
modules to allow on-line integration of G2 with external programs, systems,
and databases. The Company offers interfaces to many standard databases such
as those offered by Informix, Oracle, and Sybase. Interfaces to most popular
factory control systems are available either from the Company and its partners
or, in several cases, directly from the vendors of these systems.
 
G2-BASED PRODUCTS
 
  The Company also offers a number of products that are built on G2. The
Company's G2-based products include the following.
 
 G2 Diagnostic Assistant
 
  G2 Diagnostic Assistant ("GDA") can be used to create diagnostic and control
applications. GDA is based on functional blocks, which are graphical objects
that can be selected from menus and connected to create an
 
                                       7
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application. The functional blocks include logic and fuzzy logic blocks, rule
blocks, statistical tests, and alarm actions. New blocks can be created by the
user and added to the application to address specific needs. GDA has built-in
facilities for alarm handling and explanations of diagnostic conclusions,
including the capability to quantify the degree of certainty of such
conclusions.
 
 NeurOn-Line
 
  NeurOn-Line allows non-programmers who have little or no experience with
neural networks to take advantage of this technology, particularly for on-
line, dynamic applications. NeurOn-Line can identify and generate models of
the physical behavior of processes and of relationships among process
variables, when given a sufficient set of data. These models can then be used
on-line to compare process behavior with the model's prediction and to control
processes. The development of neural network applications in NeurOn-Line is
done graphically by selecting objects from menus, connecting them, and
entering attribute and control information.
 
 ReThink
 
  ReThink is a software tool for the design, simulation and operational
management of business processes. Using ReThink, process teams can work
together to explore alternative business process designs quickly and easily on
an electronic "canvas". Graphical blocks are connected to describe the
sequences and interdependencies among processing tasks. ReThink brings process
designs to life using computer animation, making it easy to visualize complex
business processes and measure their performance. ReThink "what-if" analyses
can calculate the financial and performance impact of policy and process
changes. ReThink modelers draw upon G2's strength in integration, putting
process models on-line to create process monitoring, executive information
systems, or workflow control applications. ReThink was first released in 1996
and there are currently over 130 copies deployed.
 
 Operations Expert
 
  Operations Expert (OPEX), formerly "Fault Expert", released in early 1997,
is a toolkit that helps solve network management problems, such as alarm
flooding, traffic congestion, and lost connections. Operations Expert is used
to filter, correlate, and prioritize alarms; recognize patterns and predict
incipient failures; and diagnose problems and recommend corrective actions to
operations personnel. Operations Expert augments standard network management
software such as HP OpenView, DEC Polycenter and IBM NetView, adding
capabilities for higher level diagnostics and rule-based reasoning.
 
PRODUCTS UNDER DEVELOPMENT
 
  The Company is presently developing new G2-related products. The products
listed below are in various stages of development and pre-release and are
expected to be released within the next twelve months.
 
 Telewindows 2
 
  Telewindows 2 is a new component based Graphical User Interface (GUI) for G2
that fully utilizes the native graphics capability of the client platform.
This product complies with Microsoft Windows and MOTIF standards and is
designed to run concurrently with the existing Telewindows product.
Telewindows 2 permits a G2 client to be developed and deployed within industry
standard programming environments, such as Visual Basic, Microsoft Explorer,
and Netscape Navigator. It also allows G2 programming components, such as its
workspaces and editors, to be presented in a standards compliant manner and
supports the integration of both JavaBean and DCOM/ActiveX components into the
client part of a G2 application. Telewindows 2 is installed at several beta
sites, and release is anticipated in the second half of 1998.
 
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 G2 JavaLink
 
  G2 JavaLink is a connectivity product that allows G2 applications to
interoperate with other software components developed using the Java
programming language and runtime environment. Java is an industry standard
language developed by SUN Microsystems for implementing software that is
highly portable across multiple platforms and operating systems. This
portability is very complementary to G2's portability. Using this product, G2
applications can leverage the growing number of available libraries of Java
component software. G2 Java Link is installed at several beta sites, and
release is currently anticipated in the second half of 1998.
 
 G2 ActiveXLink
 
  G2 ActiveXLink is a connectivity product that allows G2 applications to
interoperate with other software components developed to comply with the
Microsoft DCOM/ActiveX standards. This product allows G2 applications to
interoperate with such industry standard software as EXCEL, Visual Basic, and
PowerPoint. Using this product, G2 applications can leverage the growing
amount of available software that conforms to the Microsoft DCOM/ActiveX
standards. G2 ActiveXLink is installed at several beta sites, and release is
currently anticipated in the second half of 1998.
 
 G2 CORBALink
 
  G2 CORBA Link is a connectivity product that allows G2 applications to
interoperate with other software components in a CORBA compliant network.
CORBA (Common Object Request Broker Architecture) is an industry standard for
distributed object technology endorsed by the Object Management Group (OMG).
OMG membership includes IBM, SUN Microsystems, Oracle, Hewlett Packard, and
Netscape. Using this product, G2 applications will be able to distribute data
and request services from other CORBA compliant software in a network
transparent manner. G2 CORBALink is installed at several beta sites, and the
release is currently anticipated in the second half of 1998.
 
 G2 Agents
 
  G2 Agents are capabilities that allow programs, which conform to the Java
standard, to operate on behalf of a G2 application. G2 Agents provide a very
powerful capability to perform such services for a G2 application as
monitoring and filtering data, performing intensive numerical calculations,
and communicating with other environments, without the need of burdening G2
with these operations. When an agent determines that G2's intelligent
reasoning capability is needed, relevant data is communicated to G2, which
then performs the required actions. The G2 Agents product will allow G2 to
create, monitor, and control all agents operating on its behalf. G2 Agents are
currently planned to go into beta test at multiple sites in 1998.
 
                                       9
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CUSTOMERS AND APPLICATIONS
 
  The Company's customers include end-users, value-added resellers, systems
integrators and OEMs. Many of the largest industrial corporations in the world
are customers of the Company. Listed below is a sampling of the Company's
customers, in their respective industries:
 
 
    AEROSPACE                             FOOD AND BEVERAGE
    Boeing                                Cargill
    Hughes Aircraft                       Nabisco
    Lockheed Martin
    NASA                                  GOVERNMENT
    Storm Control Systems                 Defence Education and Research
                                          Agency (UK)
    AUTOMOTIVE                            US Army AI Center
    Ford                                  MINING
    Nissan                                IMC-Agrico
    Toyota (Japan)                        Met-Mex Penoles (Mexico)
    CEMENT                                PHARMACEUTICAL
    Lafarge (France)                      Eli Lilly
                                          Pfizer
    CHEMICAL, OIL AND GAS
    ABB Simcon                            TELECOMMUNICATIONS
    Amoco Oil                             AT&T
    AspenTech                             Ericsson Hewlett-Packard (Sweden)
    British Petroleum                     EUMETSAT (Germany)
    Citgo Petroleum                       GTE
    Exxon Chemical                        MCI
    Lagoven (Venezuela)                   Motorola
    Foxboro Company
    ICI Chemicals (UK)                    TRANSPORTATION
    Phillips Petroleum                    Aeroport International de Lyon
    Saudi Aramco                          (France)
    Shell Expro (UK)                      Railway Ministry (Russia)
    Union Carbide                         Serco Systems (UK)
                                          US Dept. of Transportation
    FINANCIAL
    Andersen Consulting
    Fidelity Investments
    MBNA
    SWIFT (Belgium)
 
  The Company has sold more than 9,000 licenses for its products to over 650
industrial, service and governmental organizations in more than 40 countries.
The Company's products are used internationally in a broad array of
applications, including the following with industries noted:
 
 CITGO Petroleum Corporation--Oil and Gas
 
  To improve plant safety and optimize its production process to achieve
greater economies of scale, CITGO Petroleum Corp. has signed a multi-refinery
agreement with Gensym that provides for site-wide use of Gensym software at
CITGO refineries in Corpus Christi, Texas; Lake Charles, Louisiana; and
Lemont, Illinois for intelligent decision support and optimization
applications. CITGO's Corpus Christi refinery was recognized by
 
                                      10
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CONTROL magazine as the 1996 Plant of the Year, based partly on its G2
applications. At its Corpus Christi plant, CITGO uses Gensym software to
provide real-time, on-line standard operating procedures that enable better
communication of knowledge between different operators and shifts.
 
 British Petroleum, Et Al--Oil and Gas
 
  Gensym and Gensym Solution Partner EDS have been awarded a contract to
develop an oil field production management system for the Eastern Trough Area
Project (ETAP) in the North Sea. A joint project of British Petroleum, Shell,
Esso, Agip, Total, Murphy, and Moex, ETAP initially entails the integrated
development of seven oil and gas accumulations. Gensym's G2 was chosen for the
Integrated Production Management Environment (IPME) for ETAP's Central
Processing Facility that will also act as an export hub for all the oil and
gas produced. G2 applications are under development for an operator advisory
system, a production forecasting system, and a capacity allocations system.
Initial implementation is scheduled to be completed by the end of March 1998.
 
 Lafarge--Process/Cement
 
  Lafarge, the world's second largest manufacturer of cement, has G2-based
intelligent systems at 35 of its 65 cement plants around the world. Lafarge
started using G2 in 1992 to control its cement kilns. Combining fuzzy logic
and expert system technology, its advanced kiln control applications allow
Lafarge to deploy proprietary knowledge enterprise-wide and standardize
control in its cement plants around the world. Lafarge has now logged more
than one million hours of on-line cement kiln control using G2. These
applications have helped the company optimize the cement-producing process,
saving money, improving product quality, and reducing emissions. Lafarge's
recent orders for G2 are for intelligent systems to control pre- and post-kiln
operations, including raw material grinding and clinker grinding. The goal of
the new applications is to further improve product quality and the economics
of production.
 
 IMC-Agrico Co.--Process/Mining
 
  IMC-Agrico, the world-leading phosphate supplier, made an initial purchase
of licenses and services for Gensym's intelligent software in 1997 as the
first step in what the two companies anticipate will be a strategic technology
relationship between them. Using Gensym software, IMC-Agrico is developing
Web-based applications for information gathering, as well as advanced process
control of its fertilizer and animal feed production. IMC-Agrico anticipates a
return on its initial investment of $1 million per site in the first year.
 
 Nabisco Biscuit Company--Food and Beverage
 
  The Nabisco Biscuit Company's Atlanta bakery wanted to reduce the waste that
results from products not meeting its strict quality standards. Simons
Engineering, a Gensym Solution Partner, worked with Nabisco to develop Process
Operator Guidelines (POG), a G2-based application that performs SCADA,
statistical process control, and recipe management functions. While providing
proactive process control advice to line operators, the POG system gives
Nabisco real-time expert analysis, allowing bakery personnel to recognize
problems quickly and respond to them intelligently. Since implementing the new
system, the Atlanta bakery has achieved higher product consistency, improved
product quality, and reduced product loss by two-thirds. Based on the success
in Atlanta, Nabisco has introduced POG in five other facilities.
 
 Ericsson Hewlett-Packard Telecommunications (EHPT)--Telecommunications
 
  As an OEM partner for Gensym, EHPT has chosen Gensym's G2 software as the
foundation for its Fault Management eXpert (FMX), an add-on to their Fault
Manager product that intelligently handles network faults. Designed to improve
network efficiency and service quality, FMX gives operators a way to distill
network experts' knowledge and use it to automate operator tasks. By enabling
routine and tedious tasks to be automated, FMX frees operators to focus on
important problems, detect them sooner, solve them quickly, and thereby
improve service quality.
 
                                      11
<PAGE>
 
 EUMETSAT--Telecommunications
 
  Comprising 17 member states, the European Organization for the Exploitation
of Meteorological Satellites (EUMETSAT) was created to establish, maintain,
and exploit European meteorological satellite systems. EUMETSAT is developing
a new family of spacecraft, Meteosat Second Generation (MSG), which are
designed to provide comprehensive weather data for European meteorologists.
First launch is planned for 2000, and the completed system is designed to
provide frequent and comprehensive meteorological data until at least 2012.
Using Gensym's G2 software, Gensym Solution partner Science Systems is
developing an intelligent system for the MSG project that will monitor and
control both the MSG satellites and the ground control centers.
 
 Motorola Satellite Communications--Telecommunications
 
  Utilizing a network of 66 low earth orbit satellites linked to ground
stations around the world, the IRIDIUM(R) network is a global personal
communications system designed to handle voice, data, fax, and paging
transmissions. IRIDIUM satellites will feature moving cells that can be shared
by access providers worldwide. Motorola's Satellite Communications Group in
Chandler, Arizona relies on Gensym's G2 and Fault Expert software to manage
this complex network and keep it operational.
 
SALES AND MARKETING
 
  In order to reach the broadest possible market, the Company utilizes its
direct sales force and over 90 selected marketing partners who have sold G2
within the last two years.
 
  The Company markets its products in North America, Europe, Africa, and parts
of Asia through a direct sales organization composed of 35 salespersons and 21
solutions engineers as of December 31, 1997. As of December 31, 1997, the
Company had nine sales offices in North America and direct sales offices in
Australia, France, Germany, Italy, Japan, the Netherlands, Singapore, Sweden,
Tunisia and the United Kingdom. The Company intends to significantly increase
its direct sales organization. In 1995, 1996, and 1997, the Company received
44%, 42%, and 46% of its total revenues, respectively, from international
operations. See Note 8 of Notes to Consolidated Financial Statements for
financial information by geographic area.
 
  The direct sales force, supported by the Company's three strategic business
units, focuses on selling to major accounts and provides face-to-face contact
with customers. Solutions engineers work with the direct sales force to
perform demonstrations at customer sites and to assist customers in evaluating
their technical requirements and implementing G2 application prototypes.
Regular seminars and workshops are hosted at the Company's larger offices to
demonstrate the G2 family of products and related applications. The Company's
local offices offer basic and advanced training courses that teach prospective
and new customers how to build application solutions using the Company's G2
and G2 based products.
 
  The Company also distributes its products through a network of over 90
systems integrators and value-added resellers who are selected for their
capability to add substantial value by providing end-users with focused
application solutions built on G2. These systems integrators and VARs
currently include organizations such as ABB, Control Software, EDS, The
Foxboro Company, Science Systems, and Storm Control Systems. Product revenues
from systems integrators and value-added resellers represented over 26%, 28%,
and 35% of the Company's product revenues for 1995, 1996, and 1997,
respectively.
 
  Gensym markets its products in Japan, Brazil, South Africa and certain other
countries through distributors. These distributors have technical competence
in the application of G2, market the Company's products, provide local
training and support assistance to customers, translate documentation, help
localize software and provide systems integration services. Sales of the
Company's products by distributors, primarily the Company's Japanese
distributor, accounted for 14%, 14%, and 8% of the Company's product revenues
in 1995, 1996, and 1997, respectively.
 
  Gensym seeks to establish relationships with OEMs, who embed G2 as part of
their products, to broaden the application of its technology and to pursue
additional market segments. Gensym has established relationships
 
                                      12
<PAGE>
 
with several OEMs including Ericsson Hewlett-Packard Telecommunications
("EHPT") and Motorola. EHPT has chosen Gensym's G2 software as the foundation
for its Fault Management eXpert (FMX) product that intelligently handles
network faults.
 
  The Company's marketing personnel are engaged in a variety of activities,
including lead generation, seminars, trade shows, public relations, direct
marketing, advertising, and promotion of customer applications for publication
in industry magazines and journals. More than 300 case studies of successful
G2 applications have been documented.
 
SERVICE AND SUPPORT
 
  Gensym believes that a high level of customer service and support is
critical to customer satisfaction and project and application success. Most
Gensym customers attend one to three weeks of training and implement their
applications using the development features of Gensym software. The Company
offers a regular schedule of courses in its offices in North America, Europe,
and Asia/Pacific, and special on-site training courses are offered on a demand
basis around the world. Direct application engineering services are available
to customers around the world, to support end-users as well as Gensym
marketing partners.
 
  The Company offers several customer service options that all include various
levels of telephone support, software updates for major releases, FTP bulletin
board access, membership to Gensym User Society and access to HelpLink, a
workflow enabled web application that greatly enhances the service experience.
The highest level of customer service support includes 24x7 callback service.
Maintenance is mandatory for the first year after purchase and may be renewed
in subsequent years. Gensym typically charges a percentage of the list price
license fee of the underlying product for customer service and offers
discounts for multiple year customer support contracts. The Company has
service centers located in North America and in Europe. Service is also
provided by local marketing partners in Japan and in other areas of the world.
 
  Gensym offers a variety of application engineering and consulting services
on a fee-for-service basis. Gensym has expertise in applying its software in a
variety of areas including network and systems management; manufacturing
process management; process design, modeling, and simulation; pharmaceutical
process design and control; water treatment; logistics; transportation; and
finance. A key mission of the consulting staff is to assist partners, as well
as end-users, in the successful development and deployment of intelligent
systems applications based on G2. As of December 31, 1997, the Company
employed a staff of 38 full-time consultants, which it supplements, when
necessary, with external contractors.
 
  The Company offers a progressive series of introductory, intermediate and
advanced training courses for customers, partners and potential users of its
products. The courses are taught at the Company's corporate headquarters in
Cambridge, at its worldwide sales offices and at customer locations. In 1997,
more than 1,400 individuals worldwide completed courses offered by the
Company.
 
  Gensym provides continuing support to the Gensym Users Society, an
organization of all G2 users covered by current maintenance contracts. The
Society sponsors an annual worldwide meeting plus additional regional and
local meetings. These meetings are organized as professional technical
conferences, with formal presentations of G2 applications by end-users and
partners, company and product updates by Gensym, product planning forums,
panel discussions, tutorials, workshops, and site visits.
 
RESEARCH AND DEVELOPMENT
 
  The Company believes that its future success will depend upon its ability to
enhance existing products as well as to develop and introduce new products
that keep pace with technological developments in the marketplace and address
the increasingly sophisticated needs of its customers. The Company intends to
expand existing product offerings and to introduce new applications. While the
Company expects that certain new products will be developed internally, the
Company may, based on timing and cost considerations, acquire or license
technology and/or products from third parties or consultants.
 
                                      13
<PAGE>
 
  New products and enhancements to existing products are typically developed
in response to discussions at user groups and customer feedback obtained by
the Company's customer support personnel. New product initiatives are also
taken to address targeted markets and industry standards. Recent areas of
focus include conformance to Microsoft Windows and NT standards (including
DCOM/ActiveX), CORBA compliance, component-based product architectures,
Internet and World Wide Web technologies (standard browsers and Java/RMI), and
agent-based intelligent systems.
 
  As of December 31, 1997, Gensym had 53 employees engaged in research and
development, including software and hardware engineering, test and quality
assurance and technical documentation. In 1995, 1996 and 1997, Gensym's
research and development expenditures totaled $5.3 million, $6.0 million, and
$7.0 million, respectively, representing 18.7%, 16.1% and 19.6% of total
revenues, respectively.
 
COMPETITION
 
  The Company believes that there are no other commercially available products
that offer the full range of capabilities embodied in the Company's products.
While a number of software companies offer products that perform certain of
the functions of G2 for specific applications, the Company believes that the
Company's products offer, as a single seamlessly integrated environment, the
most comprehensive set of software technologies available to build
successfully a broad range of intelligent system applications. Across all of
the Company's markets, competition includes "point solutions", real-time and
expert system products and traditional programming or internally developed
software. In addition, virtually all of the Company's customers have
significant investments in their existing solutions and have the resources
necessary to enhance existing products and to develop future products.
 
  Certain companies such as Objective Systems Integrators, Inc. and Pavilion
sell "point solutions" that compete with the Company's products with respect
to specific applications or uses. However, an intelligent system based on
point solutions requires the integration of various software packages from
different vendors, and is often difficult to maintain. Although they may
provide a faster implementation, such systems may fail to provide the
capabilities and flexibility needed to satisfy the changing requirements of a
dynamic complex environment. Point solutions may also fail to provide the
extensibility to add rules and neural networks, and may be difficult to
migrate to more powerful computers.
 
  Several companies including Comdale Technologies and Ilog S.A. offer
products with limited real-time or expert system development capabilities at
lower price points than those provided by the Company. These products often
require extensive programming with languages such as C or C++ for complete
implementation. The Company believes that these products lack the
comprehensive capabilities of its G2 environment and G2-based products, and
therefore have limitations in the types of operational problems that they can
address relative to G2.
 
  Some potential customers opt to build their own intelligent systems using
traditional programming languages. These systems require that knowledge be
programmed, usually at a high cost, and are typically difficult to adapt,
reuse, maintain, and scale up. Building an intelligent system using
traditional programming is a major effort that is often impractical--
particularly for applications that work in real time.
 
  The principal competitive factors in all of the Company's markets are
functionality, ease of use, price, distribution capabilities, quality,
performance, customer support, and availability of application software
implementation services. The Company believes that its products are superior
in terms of functionality, ease of use, and performance in the advanced
applications that constitute the Company's principal market, and that it
competes favorably on the basis of these factors. In order to maintain its
competitive position, the Company must continue to enhance its existing
products and introduce new products that meet evolving customer requirements.
It must also maintain a valid perceived value proposition in comparison with
its expert systems competitors. There is no assurance that the market position
or the competitive advantages of the Company will continue. See "Certain
Factors That May Affect Future Results--Competitors".
 
 
                                      14
<PAGE>
 
PROPRIETARY RIGHTS
 
  The Company relies primarily on a combination of patent law, copyright law
and trade secret law to protect its proprietary technology. The Company also
has internal policies and systems to limit access to and keep confidential its
trade secrets. The Company distributes its products under software license
agreements that contain various provisions to protect the Company's ownership
of and the confidentiality of the underlying technology. The Company also
requires its employees and other parties with access to its confidential
information to execute agreements prohibiting the unauthorized use or
disclosure of the Company's technology. In addition, the Company periodically
reviews its proprietary technology for patentability and has one patent
covering specific aspects of G2. The Company has also placed technical
inhibitors in its software that prevent the software from running on
unauthorized computers. Despite these precautions, it may be possible for a
third party to misappropriate the Company's technology or to independently
develop similar technology. In addition, effective patent, copyright and trade
secret protection may not be available in every foreign county in which the
Company's products are distributed.
 
  Certain technology used in the Company's products is licensed from third
parties. The Company believes that, in general, comparable licenses are
available on commercially comparable terms from a number of licensors and does
not believe that any of the Company's products are significantly dependent
upon such licensed technologies.
 
  Despite the Company's efforts to protect its proprietary rights, attempts
may be made to copy or reverse engineer aspects of the Company's products or
to obtain and use information that the Company regards as proprietary. There
can be no assurance that others will not develop products that infringe the
Company's proprietary rights or are similar or superior to those developed by
the Company. Policing the unauthorized use of the Company's products is
difficult. Litigation may be necessary in the future to enforce the Company's
intellectual property rights, to protect the Company's trade secrets or to
determine the validity and scope of the proprietary rights of others. Such
litigation could result in substantial costs and diversion of resources and
could have a material adverse effect on the Company's business, results of
operations and financial condition. Also, there can be no assurance that third
parties will not assert infringement claims against the Company in the future
with respect to current or future products. Any such assertion could require
the Company to enter into royalty arrangements or result in costly litigation,
which could have a material adverse effect on the Company's business, results
of operations and financial condition.
 
  Gensym, G2, NeurOn-Line and ReThink are registered trademarks of the
Company. The Gensym logo, GDA, ReThink, G2 WebLink, Operations Expert and OPEX
are trademarks of the Company. The Company has filed applications to register
Gensym, G2, NeurOn-Line, Operations Expert and OPEX in certain foreign
jurisdictions. In addition, the Company has an exclusive, worldwide, royalty-
free, perpetual license from Microsoft Corporation to use the trademark
Telewindows.
 
BACKLOG
 
  The Company ships software products within a short period after receipt of
an order and typically does not have a material backlog of unfilled orders of
software products. Therefore, revenues from software licenses in any quarter
are substantially dependent on orders booked in that quarter.
 
EMPLOYEES
 
  As of December 31, 1997, the Company had 253 full-time employees, including
91 in sales and marketing, 53 in product development, 42 in consulting
services, 32 in customer support, production and licensing, and educational
services, and 35 in general and administrative functions. None of the
Company's employees is represented by a labor union, and the Company believes
that its employee relations are good.
 
                                      15
<PAGE>
 
ITEM 2. PROPERTIES
 
  The Company's headquarters and principal operations are located in a leased
facility with 66,000 square feet in Cambridge, Massachusetts. In 1997 the
Company signed an agreement subleasing 18,500 square feet of this space for
the remainder of the lease term. The Company's lease expires on December 31,
2000 and contains a commitment to increase the amount of space to 71,000
square feet in 1999. In addition to rental expenses, the Company must also pay
an allocated portion of operating expenses and taxes each year. The Company
also leases sales office space in the metropolitan areas of several cities
throughout North America, as well as Australia, France, Germany, Italy, Japan,
the Netherlands, Singapore, Sweden, Tunisia and the United Kingdom. The
Company has a European customer support and services center in Leiden, the
Netherlands, where it leases over 9,000 square feet of office space. The
Company's aggregate rental expense, net of rental income from sub-leases, for
all facilities during 1997 was $2.8 million. Gensym believes that its existing
facilities are adequate for its current needs, and that suitable additional
space will be available as required.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is not a party to any material legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matter was submitted to a vote of the Company's security holders during
the fourth quarter of 1997.
 
EXECUTIVE OFFICERS OF THE COMPANY
 
  The executive officers of the Company and their respective ages as of March
10, 1998 are as follows:
 
<TABLE>
<CAPTION>
   NAME                     AGE                     POSITION
   ----                     ---                     --------
   <C>                      <C> <S>
   Lowell B. Hawkinson.....  55 Chairman of the Board, Chief Executive Officer,
                                 Treasurer and Secretary
   Robert L. Moore.........  55 President and Director
   Richard M. Darer........  44 Senior Vice President, Finance and
                                 Administration and Chief Financial Officer
   Stephen R. Quehl........  45 Senior Vice President, Worldwide Field
                                 Operations
   William H. Wood.........  59 Senior Vice President, Communications Business
                                 Unit and Corporate Marketing
   Troy A. Heindel.........  36 Vice President, Support Services and Chief
                                 Information Officer
   James T. Pepe...........  53 Vice President, Product Development
   Mark H. Whitworth.......  46 Vice President, Advanced Systems Business Unit
</TABLE>
 
  Mr. Hawkinson, a founder of the Company, has served as Chairman of the
Board, Chief Executive Officer, Treasurer and Secretary since September 1986.
Prior to founding the Company, Mr. Hawkinson was a Manager of Expert Systems
Development at Lisp Machines Inc., a specialty computer manufacturer, from
1983 to 1986. From 1973 to 1983, Mr. Hawkinson was Research Associate in the
field of artificial intelligence at the Laboratory for Computer Science at the
Massachusetts Institute of Technology. Mr. Hawkinson is also a director of
GenRad, Inc.
 
  Dr. Moore, a founder of the Company, has served as President and a director
since September 1986. Prior to founding the Company, Dr. Moore founded and was
Vice President of the Process Systems Division of Lisp Machines Inc. from 1983
to 1986. From 1981 to 1983, Dr. Moore was President of Sentrol Systems Inc., a
supplier of process control systems. Dr. Moore received his undergraduate
degrees in Electrical Engineering and Engineering Mathematics from the
University of Michigan, his Ph.D. degree from the Massachusetts Institute of
Technology, with a major in Automatic Control and a minor in Industrial
Management.
 
                                      16
<PAGE>
 
  Mr. Darer has served as Vice President, Finance and Administration and Chief
Financial Officer since joining the Company in April 1997. From May 1996 to
March 1997 he was Chief Financial Officer and Vice President of Administration
at White Pine Software, Inc., a videoconferencing software products company.
Mr. Darer served as Vice President, Treasurer and Controller of Sequoia
Systems, Inc., a computer systems company, from January 1996 to May 1996, and
Corporate Controller from July 1994 to December 1995. From 1982 to 1994, Mr.
Darer held several positions in financial management at Computervision
Corporation, a CAD/CAM software and services company. Mr. Darer received an
M.B.A. from Harvard University, an M.S. from Northeastern University and a
B.S. from the Polytechnic Institute of Brooklyn.
 
  Mr. Quehl has served as Senior Vice President, Worldwide Field Operations
since joining the Company in October 1997. From September 1994 to August 1997
he was Senior Vice President, Americas Field Operations at Wang Software, Wang
Laboratories, Inc., which later became Eastman Software, Inc., a subsidiary of
Eastman Kodak. From 1989 to 1994, Mr. Quehl held several executive positions
at ViewStar Corporation, a work management software and services company. His
prior field operations management experience includes positions at Cullinet
Software, Tominy, Inc and IBM Corporation. Mr. Quehl received a B.A. from the
University of Notre Dame and an M.B.A. from Xavier University.
 
  Mr. Wood has served as Vice President, Communications Business Unit since
March 1997. Since September 1997 he has served concurrently as Vice President
of Corporate Marketing. From July 1995 through December 1996 Mr. Wood was Vice
President and General Manager, North American Operations of Information
Systems Management at Bull Information Systems. Mr. Wood held various senior
management positions at Candle Corporation from 1984 to July 1995, where he
most recently served as Vice President of Worldwide Marketing. His prior sales
and marketing experience includes positions with IBM and Xerox. Mr. Wood has a
B.S. in Mechanical Engineering from University of Cincinnati.
 
  Mr. Heindel joined the Company in 1991 as a telecommunications marketing
specialist and was promoted to his current position of Vice President, Support
Services and Chief Information Officer in November 1995. Prior to joining
Gensym, Mr. Heindel worked at NASA's Johnson Space Center as a Space Shuttle
Operations Flight Controller and Project Manager from 1985 to 1991. Mr.
Heindel has a B.S. in Computational and Applied Mathematics from the
University of Connecticut and an M.S. in Mathematics from the University of
Houston.
 
  Dr. Pepe joined the Company in June 1994 as Vice President of Product
Development. From 1990 to 1994, Dr. Pepe served with Digital Equipment
Corporation as Group Manager for transaction processing software development.
Dr. Pepe holds SB, SM, and Ph.D. degrees in mathematics from the Massachusetts
Institute of Technology.
 
  Mr. Whitworth joined the Company in July 1992 as its Director of Consulting
Services and has served as Vice President, Advanced Systems Business Unit
since January 1997. From May 1995 to December 1996 Mr. Whitworth served as the
Vice President of Consulting Services. Prior to joining the Company,
Mr. Whitworth was Director of Consulting Services at MainStream Software
Company from 1990 to 1992. Mr. Whitworth has an A.B. in Mathematics from Colby
College and an M.S. in Computer Science from the University of Oregon.
 
                                      17
<PAGE>
 
                                   PART II.
 
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
        MATTERS
 
  (A) MARKET INFORMATION
 
  The common stock of the Company is traded on The Nasdaq Stock Market
("Nasdaq") under the symbol "GNSM". The common stock was first traded on
Nasdaq on February 16, 1996. Prior to the Company's initial public offering of
common stock ("the Offering") there was no established public trading market
for the Company's shares of common stock.
 
  The table below sets forth the high and low sales prices of the Company's
Common Stock in 1996 from February 16, 1996, the date of the Offering, through
the end of the first quarter of 1996 and for each full quarterly period
thereafter.
 
<TABLE>
<CAPTION>
              1996                                                HIGH     LOW
              ----                                               ------- -------
       <S>                                                       <C>     <C>
       First quarter (from February 16, 1996)................... 19 1/2  10
       Second quarter........................................... 23 3/4  18 1/4
       Third quarter............................................ 23 3/4  18 3/4
       Fourth quarter........................................... 22 3/8   8 5/8
<CAPTION>
         1997                                                     HIGH     LOW
         ----                                                    ------- -------
       <S>                                                       <C>     <C>
       First quarter............................................ 15 1/4   7 5/8
       Second quarter...........................................  7       4 1/2
       Third quarter............................................  6       4 1/4
       Fourth quarter...........................................  7 1/4   4 9/16
</TABLE>
 
  The Company has never declared or paid cash dividends on its capital stock.
The Company currently intends to retain its earnings for future growth and,
therefore does not anticipate paying any cash dividends in the foreseeable
future. Payment of future dividends, if any, will be at the discretion of the
Company's Board of Directors after taking into account various factors,
including the Company's financial condition, operating results, current and
anticipated cash needs and plans for expansion.
 
  The number of holders of record of the Company's Common Stock at March 10,
1998 was 133. This number does not include shareholders for whom shares are
held in a "nominee" or "street" name.
 
  (B) CHANGES IN SECURITIES AND USE OF PROCEEDS
 
  The following information is provided pursuant to Rule 463 under the
Securities Act of 1933, as amended (the "Securities Act"), with respect to the
Company's first registration statement filed pursuant to the Securities Act,
and updates the information previously reported in the Company's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1997:
 
<TABLE>
       <S>                                              <C>
       Effective date of the Registration Statement:    February 15, 1996
       Securities and Exchange Commission file number:  33-80727
       Use of Proceeds:
         Working Capital                                $11,952,392
</TABLE>
--------
Note: The information reported in this Item 5(b) assumes that the proceeds of
      the offering have been applied to the Company's working capital
      requirements since the date of the offering, before the use of any other
      source of cash.
 
 
                                      18
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA
 
  The selected consolidated balance sheet data presented below as of December
31, 1997 and 1996, and the selected consolidated statement of operations data
for each of the three years in the period ended December 31, 1997, are derived
from the Company's Consolidated Financial Statements, included elsewhere in
this Annual Report which have been audited by Arthur Andersen LLP, independent
public accountants (the "Consolidated Financial Statements"). The selected
consolidated balance sheet data presented below as of December 31, 1995, 1994,
and 1993 and the selected consolidated statement of operations data for the
years ended December 31, 1994 and 1993 are derived from the Company's
Consolidated Financial Statements, not included in this Annual Report on Form
10-K, all of which have been audited by Arthur Andersen LLP, independent
public accountants. These data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Consolidated Financial Statements and related Notes
included elsewhere in this Annual Report on Form 10-K.
 
<TABLE>
<CAPTION>
                                            YEAR ENDED DECEMBER 31,
                          ------------------------------------------------------------
                             1997         1996        1995        1994        1993
                          -----------  ----------- ----------- ----------- -----------
<S>                       <C>          <C>         <C>         <C>         <C>
CONSOLIDATED STATEMENT
 OF OPERATIONS DATA:
Revenues:
 Product................  $18,433,520  $21,358,295 $16,438,400 $11,426,593 $11,280,211
 Service................   17,075,603   15,877,240  11,702,577   8,164,778   6,470,862
                          -----------  ----------- ----------- ----------- -----------
   Total revenues.......   35,509,123   37,235,535  28,140,977  19,591,371  17,751,073
                          -----------  ----------- ----------- ----------- -----------
Cost of revenues........    9,352,348    7,385,215   5,314,654   2,823,037   2,001,077
                          -----------  ----------- ----------- ----------- -----------
Gross profit............   26,156,775   29,850,320  22,826,323  16,768,334  15,749,996
                          -----------  ----------- ----------- ----------- -----------
Operating expenses:
 Sales and marketing....   18,802,113   17,432,861  14,568,045   9,371,574   7,747,776
 Research and
  development...........    6,977,143    5,983,741   5,267,461   4,590,220   4,070,243
 General and
  administrative........    4,528,147    3,699,254   2,619,103   2,630,943   2,004,783
 Restructuring charge...    1,557,253          --          --          --          --
                          -----------  ----------- ----------- ----------- -----------
   Total operating
    expenses............   31,864,656   27,115,856  22,454,609  16,592,737  13,822,802
                          -----------  ----------- ----------- ----------- -----------
Operating income (loss).   (5,707,881)   2,734,464     371,714     175,597   1,927,194
Other income, net.......      779,118      517,758     236,030     258,077      78,223
                          -----------  ----------- ----------- ----------- -----------
Income (loss) before
 provision for income
 taxes..................   (4,928,763)   3,252,222     607,744     433,674   2,005,417
Provision for income
 taxes..................       40,000    1,204,000     411,000     302,000     772,000
                          -----------  ----------- ----------- ----------- -----------
Net income (loss).......  $(4,968,763) $ 2,048,222 $   196,744 $   131,674 $ 1,233,417
                          ===========  =========== =========== =========== ===========
Basic income (loss) per
 share(1)(2)............  $     (0.79) $      0.35 $      0.05 $      0.03 $      0.31
                          ===========  =========== =========== =========== ===========
Diluted income (loss)
 per share(1)(2)........  $     (0.79) $      0.33 $      0.04 $      0.03 $      0.26
                          ===========  =========== =========== =========== ===========
Weighted average common
 shares
 outstanding(1)(2)......    6,309,815    5,909,511   3,993,600   3,990,531   3,972,146
                          ===========  =========== =========== =========== ===========
Weighted average common
 shares outstanding
 assuming
 dilution(1)(2).........    6,309,815    6,286,170   4,762,245   4,758,411   4,746,239
                          ===========  =========== =========== =========== ===========
CONSOLIDATED BALANCE
 SHEET DATA:
Cash, cash equivalents
 and short-term
 investments............  $15,801,349  $19,589,852 $ 5,092,201 $ 6,772,671 $ 5,805,469
Working capital.........   15,148,820   20,469,778   6,176,328   6,585,277   6,542,286
Total assets............   31,517,107   36,257,621  17,846,495  14,335,231  13,189,483
Long-term obligations,
 less current portion...          --           --          --          --          --
Total stockholders'
 equity.................   19,828,365   24,068,455   8,610,577   8,360,244   8,199,878
</TABLE>
--------
(1)  Computed as described in Note 1(i) of Notes to Consolidated Financial
     Statements.
 
(2)  Income (loss) per share has been restated for the effect of adopting SFAS
     No. 128, Earnings per Share.
 
                                      19
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
OVERVIEW
 
  The Company was incorporated in 1986 to provide software products for
developing and deploying intelligent systems for managing and optimizing
complex operations. The Company released the first version of G2, its core
product, in May 1988, and since that time has introduced enhanced versions of
G2 and has expanded its product line to include several G2-based application
products as well as several G2 connectivity products. In addition, the Company
derives significant service revenues from maintenance contracts, consulting
services, and training courses related to its software products.
 
  The Company markets and sells its products through its direct sales force in
the United States, Europe, Africa, and Asia, as well as through selected
distributors in other countries, including Japan. The Company also sells its
products through a network of value-added resellers and systems integrators
who provide consulting services and integrated solutions to their customers.
The Company has also licensed OEM customers to include the Company's software
as part of the OEM's complete solution offering.
 
  During the first quarter of 1997, the Company underwent a major
reorganization and adopted a solutions-oriented approach in the sales and
marketing organizations to better meet the buying requirements of companies in
its primary target markets. This approach required a strategic reorganization
and retraining of the sales force, and a major change in sales account
structure. At the same time, the Company established three strategic business
units, Manufacturing, Communications, and Advanced Systems, to manage the
domain-specific expertise, products, and services required to serve mainstream
customers in their respective focus markets. Gensym intends to continue to
expand the market for intelligent systems by selling and delivering tools and
solutions with and through partners to large organizations with complex
operations and the potential for extensive application proliferation.
 
  The strategic reorganization and retraining of the sales force extended the
Company's sales cycle and resulted in lower license booking levels, especially
in the United States. By the second quarter of 1997, the Company was unable to
sustain profitable operations at the existing resource levels and therefore
formalized a plan of restructuring intended to lower operating expenses by
reducing its workforce by 15%, closing and consolidating several field sales
offices, and consolidating space in its corporate headquarters. Accordingly,
the Company recorded a restructuring charge of approximately $1.6 million in
fiscal 1997.
 
  This Annual Report on Form 10-K contains forward-looking statements. For
this purpose, any statements contained herein that are not statements of
historical fact may be deemed to be forward-looking statements. Without
limiting the foregoing, the words "believes," "anticipates," "plans,"
"expects," "intends" and similar expressions are intended to identify forward-
looking statements. There are a number of important factors that could cause
the Company's actual results to differ materially from those indicated by such
forward-looking statements. These factors include, without limitation, those
set forth below under the caption "Certain Factors That May Affect Future
Results".
 
                                      20
<PAGE>
 
RESULTS OF OPERATIONS
 
  The following table sets forth, as a percentage of total revenues,
consolidated statements of operations data for the periods indicated:
<TABLE>
<CAPTION>
                                 YEAR ENDED DECEMBER 31,
                                 --------------------------
                                  1997      1996     1995
                                 -------   -------  -------
   <S>                           <C>       <C>      <C>
   Revenues:
     Product...................     51.9%     57.4%    58.4%
     Service...................     48.1      42.6     41.6
                                 -------   -------  -------
       Total revenues..........    100.0     100.0    100.0
                                 -------   -------  -------
   Cost of revenues............     26.3      19.9     18.9
                                 -------   -------  -------
   Gross margin................     73.7      80.1     81.1
                                 -------   -------  -------
   Operating expenses:
     Sales and marketing.......     53.0      46.8     51.8
     Research and development..     19.6      16.1     18.7
     General and
      administrative...........     12.8       9.9      9.3
     Restructuring charge......      4.4       --       --
                                 -------   -------  -------
       Total operating
        expenses...............     89.8      72.8     79.8
                                 -------   -------  -------
   Operating income (loss).....    (16.1)      7.3      1.3
   Other income, net...........      2.2       1.4      0.9
                                 -------   -------  -------
   Income (loss) before
    provision for income taxes.    (13.9)      8.7      2.2
   Provision for income taxes..      0.1       3.2      1.5
                                 -------   -------  -------
   Net income (loss)...........    (14.0)%     5.5%     0.7%
                                 =======   =======  =======
</TABLE>
 
YEARS ENDED DECEMBER 31, 1997 AND 1996
 
REVENUES
 
  The Company's revenues are derived from two sources: product licenses and
services. Product revenues include revenues from sales of licenses for use of
G2 and associated software products. Service revenues consist of fees for
maintenance contracts, consulting services, and training courses related to
the Company's products.
 
  Total revenues were $35.5 million for the year ended December 31, 1997 as
compared to $37.2 million for 1996, a decrease of $1.7 million or 4.6%. The
decrease in total revenues was attributable to decreased sales of product
licenses, partially offset by an increase in service revenues. International
revenues accounted for 46% and 42% of total revenue in 1997 and 1996,
respectively.
 
  Product. Product revenues decreased to $18.4 million for the year ended
December 31, 1997 from $21.4 million in 1996, a decrease of 13.7%. The
decrease in product revenues reflected lower bookings in 1997, which the
Company believes is primarily due to the reorganization of the Company's sales
force, especially in the Americas, and a longer sales cycle caused by the
Company's shift to a solutions-oriented approach in the sales and marketing
organizations. In addition, orders from the Company's distributor in Japan
slowed considerably in the year ended December 31, 1997 as compared to 1996.
The Company does not have a material amount of backlog at any given time.
 
  Service. Service revenues increased to $17.1 million for the year ended
December 31, 1997 from $15.9 million in the same period in 1996, an increase
of 7.5%. The increase in service revenues was primarily due to increased
maintenance fees derived from an increased customer base. Maintenance fees
increased to $8.9 million for the year ended December 31, 1997 from $7.9
million in the same period in 1996, an increase of 13.6%. Consulting revenues
increased to $6.5 million for the year ended December 31, 1997 from $6.1
million
 
                                      21
<PAGE>
 
in the same period in 1996, an increase of 6.2%. The Company expects to
continue to expand its application consulting resources to meet the growing
demand from customers and partners for a solutions-oriented approach for
application design and development.
 
COST OF REVENUES
 
  Cost of revenues primarily consists of consulting labor, technical support
costs and the costs of material and labor involved in producing and
distributing the Company's software. Cost of revenues increased to
$9.4 million in 1997 from $7.4 million in 1996, an increase of 26.6%. This
increase was primarily due to an increase in consulting labor costs. Gross
margin on revenues decreased to 73.7% for the year ended December 31, 1997
from 80.1% in the same period in 1996. This decrease in gross margin reflected
primarily a higher percentage of lower margin service revenues as a percentage
of total revenues, and to a lesser extent, an increase in consulting
personnel, including outside contractors, and in technical support personnel.
The Company anticipates that higher margin revenues will increase as a
percentage of total revenues, and that the overall gross margin will increase.
 
OPERATING EXPENSES
 
  In June, 1997, the Company implemented a plan of restructuring intended to
lower operating expenses in subsequent periods by reducing its workforce by
approximately 15%, closing and consolidating several field sales offices, and
consolidating office space in its corporate headquarters. At December 31,
1997, the Company had taken actions in all intended areas consistent with the
restructuring plan and had charged approximately $1.1 million of costs against
the restructuring liability. As a result, the Company substantially reduced
certain operating costs, including payroll and payroll related costs, building
rent, and leased equipment in the second half of 1997. The increases in
operating expenses for the year ended December 31, 1997 as compared to 1996
occurred primarily in the first six months of those periods.
 
  Sales and Marketing. Sales and marketing expenses consist primarily of costs
associated with personnel involved in the sales and marketing process, sales
commissions, sales facilities, travel and lodging, trade shows and seminars,
advertising, and promotional materials. For the year ended December 31, 1997,
these expenses increased 7.9% to $18.8 million (53.0% of total revenues) from
$17.4 million (46.8% of total revenues) for the comparable period in 1996. The
increase in absolute dollars was primarily a result of the continued
investment in the Company's global sales and marketing resources, including
the opening of new sales offices in the United States and in Asia/Pacific. The
increase as a percentage of total revenues was primarily due to the lower
product revenues reported in 1997 as compared to 1996. While the Company plans
to hire more direct sales personnel in the coming year, the Company expects
sales and marketing expenses to decrease as a percentage of total revenues due
to a reduction in sales and marketing administrative personnel in the second
half of 1997, the consolidation of certain sales offices, as well as to
anticipated higher revenues and improved yields attributable to the strategic
reorganization and retraining of the sales force.
 
  Research and Development. Research and development expenses consist
primarily of costs of personnel, equipment, and facilities. These expenses
increased 16.6% to $7.0 million (19.6% of total revenues) for the year ended
December 31, 1997 from $6.0 million (16.1% of total revenues) for the
comparable period in 1996. The increase in absolute dollars was primarily due
to an increase in engineering personnel devoted to enhancements, new features,
and quality assurance for the G2 product family, as well as to the development
of new products. The Company achieved several major commercial releases of the
Company's products in 1997. The increase as a percentage of total revenues was
primarily due to the lower product revenues reported in 1997 as compared to
1996. The Company plans to control both hiring and overall research and
development expenses relative to anticipated future revenues during the coming
year and expects that research and development expenses will decrease as a
percentage of total revenues.
 
  General and Administrative. General and administrative expenses consist
primarily of personnel costs for finance, administration, operations,
information systems, and general management, as well as legal and
 
                                      22
<PAGE>
 
accounting expenses. These expenses increased 22.4% to $4.5 million (12.8% of
total revenues) for the year ended December 31, 1997 from $3.7 million (9.9%
of total revenues) for the comparable period in 1996. The increase in absolute
dollars was primarily due to amortization of the cost of a newly implemented
financial information system and costs related to being a public company, such
as proxy statement preparation and shareholders' meeting expenses. The
increase as a percentage of total revenues was due to the above factors as
well as to the lower product revenues reported in 1997 as compared to 1996.
The Company expects that these expenses will decline as a percentage of total
revenues primarily due to a reduction in administrative personnel in the
second half of 1997, the control of hiring, the consolidation of facilities,
other actions taken in 1997 as part of the restructuring plan, and anticipated
higher revenues.
 
  Restructuring Charge. In June 1997, the Company implemented a plan of
restructuring intended to lower operating expenses in subsequent periods by
reducing its workforce by approximately 15%, closing and consolidating several
field sales offices, and consolidating office space in its corporate
headquarters. Accordingly, the Company recorded a restructuring charge of
approximately $2.0 million in the quarter ended June 30, 1997. This amount
included $850,000 for estimated rent and lease termination costs for
consolidating facilities and equipment, $725,000 for severance and other
employee termination costs, and $425,000 for the write-off of certain assets
that would provide no future benefit to the Company as a result of the
restructuring plan. In the third quarter of 1997, the Company recorded a
restructuring credit of $485,000 for the recovery of its investment in a joint
venture, a portion of which had been written off in the previous quarter.
 
OTHER INCOME
 
  Other income consists primarily of interest income, partially offset by net
foreign exchange transaction losses and by Gensym's 50% share of the net loss
in a joint venture investment. For the year ended December 31, 1997, other
income increased to $779,000 from $518,000 for the comparable period in 1996.
In 1997, the Company sold its interest in the joint venture and recorded a
benefit from the recovery of its investment. The increase in other income is
primarily due to the benefit recorded in 1997, partially offset by an increase
in net foreign exchange transaction losses for the year ended December 31,
1997 as compared to the same period in the prior year. The Company has
historically experienced nominal net foreign exchange transaction gains or
losses. Interest income was $590,000 in 1997 as compared to $608,000 in 1996.
 
INCOME TAXES
 
  The Company generated a significant tax loss carryforward during the year
ended December 31, 1997. Under SFAS No. 109, the Company cannot recognize a
deferred tax asset for the future benefit of its tax loss carryforward unless
it concludes that it is "more likely than not" that such deferred tax asset
would be realized. Accordingly, the Company has established a valuation
allowance against its deferred tax asset to the extent that it cannot
conclusively demonstrate that these assets "more likely than not" will be
realized. In determining the amount of valuation allowance required, the
Company considers numerous factors, including historical profitability,
estimated future taxable income and the volatility of its historical earnings
and of the industry in which it operates. See Note 4 of Notes to Consolidated
Financial Statements.
 
YEARS ENDED DECEMBER 31, 1996 AND 1995
 
REVENUES
 
  Total revenues were $37.2 million for the year ended December 31, 1996 as
compared to $28.1 million in 1995, an increase of $9.1 million or 32.3%. The
increase in total revenues was attributable to increased sales of both
software product licenses and related services. International revenues
accounted for 42% and 44% of total revenue in 1996 and 1995, respectively.
 
  Product. Product revenues increased to $21.4 million for the year ended
December 31, 1996 from $16.4 million in 1995, an increase of 29.9%. The
increase in product revenues reflected the results of earlier
 
                                      23
<PAGE>
 
expansion of the Company's direct sales force, an increased number of
marketing partnerships (value-added resellers, systems integrators, and
distributors), and greater acceptance of G2 and G2-based products in both
existing and new market segments.
 
  Service. Service revenues increased to $15.9 million for the year ended
December 31, 1996 from $11.7 million for the same period in 1995, an increase
of 35.7%. The increase in service revenues was primarily due to increased
maintenance fees and application consulting. Maintenance fees increased to
$7.9 million for the year ended December 31, 1996 from $6.0 million for the
same period in 1995, an increase of 31.7%. The increase in maintenance fees
was due to a larger customer base and increased maintenance renewals.
Consulting revenues increased to $6.1 million for the year ended December 31,
1996 from $3.9 million for the same period in 1995, an increase of 55.9%.
Consulting revenues as a percentage of total revenues increased to 16.3% in
1996 from 13.8% in 1995.
 
COST OF REVENUES
 
  Cost of revenues increased to $7.4 million in 1996 from $5.3 million in
1995, an increase of 39.0%. The increase was primarily due to an increase in
consulting labor costs associated with providing increased consulting
services. Gross margin on revenues decreased to 80.1% for the year ended
December 31, 1996 from 81.1% for the same period in 1995, primarily due to a
higher percentage of lower margin service revenues as a percentage of total
revenues.
 
OPERATING EXPENSES
 
  Sales and Marketing. Sales and marketing expenses consist primarily of costs
associated with personnel involved in the sales and marketing process, sales
commissions, seminars, sales facilities expenses, trade shows, advertising,
and promotional materials. For the year ended December 31, 1996, these
expenses increased 19.7% to $17.4 million (46.8% of total revenues) from $14.6
million (51.8% of total revenues) for the comparable period in 1995. The
increase in absolute dollars was primarily a result of the continued
investment in the Company's global sales and marketing capabilities, including
the addition of sales and sales-related personnel in new and existing offices.
 
  Research and Development. Research and development expenses consist
primarily of costs of personnel, equipment, and facilities. These expenses
increased 13.6% to $6.0 million (16.1% of total revenues) for the year ended
December 31, 1996 from $5.3 million (18.7% of total revenues) for the
comparable period in 1995. The increase in absolute dollars was primarily due
to an increase in engineering personnel devoted to new product features and
enhancements in the G2 product family and the development of new products. The
decrease as a percentage of revenues was primarily due to increased revenues.
 
  General and Administrative. General and administrative expenses consist
primarily of personnel costs for finance, administration, operations,
information systems, and general management, as well as legal and accounting
expenses. These expenses increased 41.2% to $3.7 million (9.9% of total
revenues) for the year ended December 31, 1996 from $2.6 million (9.3% of
total revenues) for the comparable period in 1995. This increase was primarily
due to an increase in the number of personnel in the Company's finance,
administrative, and information systems departments.
 
OTHER INCOME
 
  Other income consists primarily of interest income and foreign exchange
transaction gains and losses. For the year ended December 31, 1996, other
income increased 119.4% to $518,000 from $236,000 for the comparable period in
1995. This increase was primarily due to an increase in interest income
related to higher cash, short-term investment, and long-term investment
balances available for investment, as a result of the proceeds from the
Company's initial public offering in February 1996, offset by losses in other
investing activities. In 1996, interest income increased 175.6% to $608,000
from $220,000 in the same period in 1995. The Company has historically
experienced nominal net foreign exchange transaction gains or losses.
 
                                      24
<PAGE>
 
INCOME TAXES
 
  The Company's effective tax rate for the years ended December 31, 1996 and
1995 was 37.0% and 67.6%, respectively. The effective tax rate for the year
ended December 31, 1995 was higher than the statutory rate principally due to
the effect of taxes on foreign income and due to foreign withholding taxes.
See Note 4 of Notes to Consolidated Financial Statements.
 
SELECTED QUARTERLY OPERATING RESULTS
 
  The Company's operating results have fluctuated in the past and may
fluctuate significantly in the future. Because the Company ships software
products within a short period after receipt of an order, the Company
typically does not have a material backlog of unfilled orders for software
products. Accordingly, revenues from software licenses in any quarter are
substantially dependent on orders for software products booked in the quarter.
 
  The revenues for a quarter typically include a number of large orders. If
the timing of any of these orders is delayed, it could result in a substantial
reduction in revenues for that quarter. Historically, a majority of each
quarter's revenues from software licenses has come from license contracts that
have been effected in the final weeks of that quarter. Since the Company's
expense levels are based in part on its expectations as to future revenues,
the Company may be unable to adjust spending in a timely manner to compensate
for any revenue shortfall. Accordingly, any revenue shortfalls would likely
have a disproportionate adverse effect on net income.
 
  The following tables present unaudited financial information for the
Company's eight most recent quarters. The following selected quarterly
information includes all adjustments (consisting only of normal recurring
adjustments) that the Company considers necessary for a fair presentation. The
Company believes that quarter-to-quarter comparisons of its financial results
are not necessarily meaningful and that such comparisons should not be relied
upon as an indication of future performance.
 
<TABLE>
<CAPTION>
                                                            QUARTER ENDED
                              ---------------------------------------------------------------------------
                              DEC. 31, SEPT. 30, JUNE 30,  MAR. 31,  DEC. 31, SEPT. 30, JUNE 30, MAR. 31,
                                1997     1997      1997      1997      1996     1996      1996     1996
                              -------- --------- --------  --------  -------- --------- -------- --------
                                                           (IN THOUSANDS)
<S>                           <C>      <C>       <C>       <C>       <C>      <C>       <C>      <C>
Revenues:
  Product....................  $5,275   $ 3,889  $ 3,337   $ 5,932   $ 6,062   $4,925    $5,649   $4,723
  Service....................   4,236     4,202    4,538     4,099     4,339    3,968     3,852    3,718
                               ------   -------  -------   -------   -------   ------    ------   ------
    Total revenues...........   9,511     8,091    7,875    10,031    10,401    8,893     9,501    8,441
                               ------   -------  -------   -------   -------   ------    ------   ------
Cost of revenues.............   2,223     2,388    2,409     2,331     2,079    1,850     1,811    1,646
                               ------   -------  -------   -------   -------   ------    ------   ------
Gross margin.................   7,288     5,703    5,466     7,700     8,322    7,043     7,690    6,795
                               ------   -------  -------   -------   -------   ------    ------   ------
Operating expenses:
  Sales and marketing........   4,583     4,471    5,038     4,711     4,559    4,317     4,344    4,214
  Research and development...   1,554     1,654    1,902     1,866     1,529    1,596     1,462    1,397
  General and administrative.   1,084     1,150    1,293     1,001     1,054      992       920      732
  Restructuring charge
   (credit)..................     --       (485)   2,042       --        --       --        --       --
                               ------   -------  -------   -------   -------   ------    ------   ------
    Total operating expenses.   7,221     6,790   10,275     7,578     7,142    6,905     6,726    6,343
                               ------   -------  -------   -------   -------   ------    ------   ------
Operating income (loss)......      67    (1,087)  (4,809)      122     1,180      138       964      452
Other income, net............     137       507      150       (16)      129      173       153       63
                               ------   -------  -------   -------   -------   ------    ------   ------
Income (loss) before
 provision for income taxes..     204      (580)  (4,659)      106     1,309      311     1,117      515
Provision for income taxes...     --        --       --         40       493      115       414      182
                               ------   -------  -------   -------   -------   ------    ------   ------
Net income (loss)............  $  204   $  (580) $(4,659)  $    66   $   816   $  196    $  703   $  333
                               ======   =======  =======   =======   =======   ======    ======   ======
</TABLE>
 
                                      25
<PAGE>
 
<TABLE>
<CAPTION>
                                                        QUARTER ENDED
                          --------------------------------------------------------------------------
                          DEC. 31, SEPT. 30, JUNE 30,  MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31,
                            1997     1997      1997      1997     1996     1996      1996     1996
                          -------- --------- --------  -------- -------- --------- -------- --------
                                             (AS A PERCENTAGE OF TOTAL REVENUES)
<S>                       <C>      <C>       <C>       <C>      <C>      <C>       <C>      <C>
Revenues:
  Product...............    55.5%     48.1%    42.4%     59.1%    58.3%     55.4%    59.5%    56.0%
  Service...............    44.5      51.9     57.6      40.9     41.7      44.6     40.5     44.0
                           -----     -----    -----     -----    -----     -----    -----    -----
    Total revenues......   100.0     100.0    100.0     100.0    100.0     100.0    100.0    100.0
                           -----     -----    -----     -----    -----     -----    -----    -----
Cost of revenues........    23.4      29.5     30.6      23.3     20.0      20.8     19.0     19.5
Gross margin............    76.6      70.5     69.4      76.7     80.0      79.2     81.0     80.5
                           -----     -----    -----     -----    -----     -----    -----    -----
Operating expenses:
  Sales and marketing...    48.2      55.3     64.0      46.9     43.8      48.5     45.7     49.9
  Research and
   development..........    16.3      20.4     24.2      18.6     14.7      17.9     15.4     16.5
  General and
   administrative.......    11.4      14.2     16.4      10.0     10.1      11.2      9.7      8.7
  Restructuring charge
   (credit).............     --       (6.0)    25.9       --       --        --       --       --
                           -----     -----    -----     -----    -----     -----    -----    -----
    Total operating
     expenses...........    75.9      83.9    130.5      75.5     68.6      77.6     70.8     75.1
                           -----     -----    -----     -----    -----     -----    -----    -----
Operating income (loss).     0.7     (13.4)   (61.1)      1.2     11.4       1.6     10.2      5.4
Other income, net.......     1.4       6.2      1.9      (0.1)     1.2       1.9      1.6      0.7
                           -----     -----    -----     -----    -----     -----    -----    -----
Income (loss) before
 provision for income
 taxes..................     2.1      (7.2)   (59.2)      1.1     12.6       3.5     11.8      6.1
Provision for income
 taxes..................     --        --       --        0.4      4.7       1.3      4.4      2.2
                           -----     -----    -----     -----    -----     -----    -----    -----
Net income (loss).......     2.1%     (7.2)%  (59.2)%     0.7%     7.9%      2.2%     7.4%     3.9%
                           =====     =====    =====     =====    =====     =====    =====    =====
</TABLE>
 
LIQUIDITY AND CAPITAL RESOURCES
 
  The Company currently finances its operations (including capital
expenditures) primarily through cash flows from operations and its current
cash and short term investment balances. In addition, the Company has
$4.0 million of equipment under operating lease arrangements. The Company's
lease commitments consist of operating leases primarily for the Company's
facilities and computers. The Company used $2.9 million in cash for operations
for the year ended December 31, 1997, generated $3.9 million in cash from
operations in 1996 and used $131,000 in cash for operations in 1995. Cash used
for operations in 1997 was primarily due to the net loss, and decreases in
accounts payable and accrued expenses, partially offset by the restructuring
charge and a decrease in accounts receivable.
 
  At December 31, 1997, the Company had cash, cash equivalents, and short-term
investments of $15.8 million. The Company regularly invests excess funds in
highly rated money market funds, government securities, and commercial paper.
In addition, the Company had long-term investments of $1.0 million, primarily
consisting of municipal bonds with maturity dates of greater than one year.
The Company received $1.1 million in 1997 through the exercise of stock
options and the sale of shares through the employee stock purchase plan.
 
  At December 31, 1997, the Company had available a bank line of credit
allowing for borrowings up to $1.0 million and providing for interest at the
prime rate. This bank line of credit will expire on May 31, 1998 and requires
the Company to comply with certain financial ratios, including minimum levels
of net worth and profitability. The Company obtained a waiver from the bank
with respect to the Company's failure to satisfy the profitability covenant as
of December 31, 1997. There were no borrowings under the bank line of credit
for the year ended December 31, 1997.
 
  Investing activities provided cash of $1.5 million in 1997, and utilized
cash of $7.2 million and $4.6 million for the years ended 1996 and 1995,
respectively. In 1997, the sales of short-term investments provided
$3.1 million, which was offset primarily by the purchases of property and
equipment ($1.2 million) and the
 
                                      26
<PAGE>
 
purchases of long-term investments ($300,000). The Company expects that its
requirements for computers, office facilities, and office equipment in 1998
will be below that of fiscal 1997 and that such equipment and facilities will
be available when needed.
 
  At December 31, 1997, the Company estimated that the cash requirement to
settle its remaining restructuring obligations would be approximately
$490,000. These cash requirements pertain primarily to lease termination costs
and are expected to be substantially fulfilled within the first half of 1998.
The Company believes that the settlement of its restructuring obligations will
not materially impact future liquidity.
 
  The Company believes that the available funds and cash generated from
operations will be sufficient to meet the Company's business requirements at
least through December 31, 1998.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
  In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 128 (SFAS No. 128), Earnings
per Share, which the Company adopted during the year. Under SFAS No. 128, the
Company is required to present both basic earnings per share and diluted
earnings per share. See Note 1(i) of Notes to Consolidated Financial
Statements.
 
  In October 1997, the American Institute of Certified Public Accountants
issued Statement of Position 97-2 ("SOP 97-2"), Software Revenue Recognition.
The Company intends to adopt this pronouncement in fiscal 1998, as required by
SOP 97-2. The Company believes that its current revenue recognition practices
are consistent with those required by SOP 97-2.
 
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
 
  A number of uncertainties exist that could affect the Company's operating
results, including, without limitation, the following:
 
  Emerging Market for Intelligent Systems. Substantially all of the Company's
revenues are derived from the licensing and support of software products that
enable organizations to implement intelligent systems for decision support and
control. Although many organizations have begun to deploy, or have announced
plans to deploy, intelligent systems, these systems are different from the
basic monitoring and control systems that are traditionally employed by these
organizations. There can be no assurance that these organizations will be able
to introduce intelligent systems successfully nor that such systems will gain
widespread acceptance. In addition, the timing of the implementation of
intelligent systems by organizations may be affected by economic factors,
government regulations, and other factors. Delays in the introduction of
intelligent systems or the failure of these systems to gain widespread market
acceptance would materially and adversely affect the Company's business,
results of operations, or financial condition. In addition, the Company
believes that end-users in its markets are increasingly seeking complete
solutions, rather than software tools with which to develop such solutions.
Meeting this demand has required the Company to modify its sales approach. The
Company is also increasingly reliant on value-added resellers and systems
integrators to deliver services to implement these solutions. The modified
sales approach may also lengthen the Company's average sales cycle. Failure by
the Company to respond appropriately to shifts in market demand could have a
material adverse effect on the Company's business, results of operations, or
financial condition.
 
  Dependence Upon Development of Sales and Marketing Force. The Company's
future success will depend, in part, upon the productivity of its sales and
marketing force and the ability of the Company to continue to attract,
integrate, train, motivate and retain new sales and marketing personnel. There
can be no assurance that the Company's investment in sales and marketing will
ultimately prove to be successful. In addition, there can be no assurance that
the Company's sales and marketing organization will be able to compete
successfully against the significantly more extensive and better funded sales
and marketing operations of many of the Company's current and potential
competitors. The Company's inability to manage its sales and marketing force
effectively could have a material adverse effect on the Company's business,
operating results and financial condition.
 
                                      27
<PAGE>
 
  Variability of Quarterly Operating Results. The Company has experienced, and
may experience in the future, significant quarter-to-quarter fluctuations in
its operating results. The Company has, on occasion, recorded quarterly
losses, and there can be no assurance that revenue growth or profitable
operations can be attained on a quarterly or annual basis in the future. The
Company's sales cycle typically ranges from six to 12 months, and the cost of
acquiring the Company's software, building and deploying applications, and
training users represents a significant expenditure for customers. The
Company's relatively long sales cycle and high license fees, together with
fixed short-term expenses, can cause significant variations in operating
results from quarter to quarter, based on a relatively small variation in the
timing of major orders. Factors such as the timing of new product
introductions and upgrades and the timing of significant orders could
contribute to this quarterly variability. In addition, the Company ships
software products within a short period after receipt of an order and
typically does not have a material backlog of unfilled orders of software
products. Therefore, revenues from software licenses in any quarter are
substantially dependent on orders booked in that quarter. Historically, a
majority of each quarter's revenues from software licenses has come from
license contracts that have been effected in the final weeks of that quarter.
The revenues for a quarter typically include a number of large orders. If the
timing of any of these orders is delayed, it could result in a substantial
reduction in revenues for that quarter. The Company's expense levels are based
in part on expectations of future revenue levels. A shortfall in expected
revenues could therefore result in a disproportionate decrease in the
Company's net income. The Company's financial performance has generally been
somewhat weaker in the first quarter than in the other fiscal quarters, due to
customer purchasing patterns.
 
  Economic Factors. Because capital expenditures are often viewed as
discretionary by organizations, sales of the Company's products for capital
budget projects are subject to general economic conditions. Such capital
expenditures are also susceptible to industry-specific economic downturns.
Certain industries have experienced weakened demand in the past, which has
adversely affected the Company's revenues, gross margin, and operating results
during such periods. There can be no assurance that future recessionary
conditions in the markets for the Company's products will not adversely affect
the Company's business, results of operations, or financial condition.
 
  Product Concentration. The Company's only current product offerings are G2,
an object-oriented development and deployment environment for building
intelligent systems, and software application products which operate in
conjunction with G2. Accordingly, the Company's business and financial results
are substantially dependent upon the continued customer acceptance and
deployment of G2 and related products. The timing of major G2 releases may
affect the timing of purchases of the Company's products. The Company has
introduced several G2-based products for building applications and is
developing others. The Company believes that market acceptance of these
products will be important to the Company's future growth. There can be no
assurance that such products will achieve market acceptance or that new
products will be successfully developed. In addition, the Company relies on
many of its marketing partners to develop G2-based products for specialized
markets. Accordingly, the Company's business and financial results are also
linked to the continued successful product development by its marketing
partners and market acceptance of such G2-based products. Any decline in the
demand for G2 and related products, whether as a result of competitive
products, price competition, the lack of success of the Company's marketing
partners, technological change, the shift in customer demand toward complete
solutions, or other factors, could have a material adverse effect on the
Company's business, results of operations, or financial condition.
 
  New Products and Rapid Technological Change. The market for the Company's
products is relatively new and is characterized by rapid technological change,
evolving industry standards, changes in end-user requirements, and frequent
new product introductions and enhancements. The Company's future success will
depend in part upon its ability to enhance its existing products, to introduce
new products and features to meet changing customer requirements and emerging
industry standards, and to manage transitions from one product release to the
next. The Company anticipates releasing new client access and object exchange
products in the second half of 1998. The Company has from time to time
experienced delays in introducing new products and product enhancements. There
can be no assurance that the Company will not experience difficulties that
could
 
                                      28
<PAGE>
 
delay or prevent the successful development, introduction and marketing of
these new products and product enhancements. Also there can be no assurance
that the Company will successfully complete the development of new or enhanced
products, that the Company will successfully manage the transition to future
versions of G2, or that the Company's future products will achieve market
acceptance. In addition, the introduction of products embodying new
technologies and the emergence of new industry standards could render the
Company's existing products and products currently under development obsolete
and unmarketable. From time to time, new products, capabilities, or
technologies may be announced that have the potential to replace or shorten
the life cycle of the Company's existing product offerings. There can be no
assurance that announcements of currently planned or other new product
offerings will not cause customers to defer purchasing existing Company
products. See "Emerging Market for Intelligent Systems".
 
  Migration to Microsoft Windows and Object Exchange Standards. The Company
believes that operating systems similar to Microsoft Windows, due to their
interoperability and customization capabilities, are increasingly the
preferred choice of many of its customers. This is also a factor in gaining
wider customer penetration. The Company is developing its next client access
product to be fully Microsoft Windows and MOTIF compliant. There can be no
assurance that the Company will be successful in developing this new product.
Any delay or failure to bring this product to market could affect the
Company's competitive position or limit its growth opportunities.
 
  Reliance Upon Indirect Distribution Channels. The Company sells its products
in part through value-added resellers, systems integrators, OEMs and
distributors, who are not under the control of the Company. Sales of the
Company's products by value-added resellers and systems integrators
represented 26%, 28% and 35% of the Company's product revenues in 1995, 1996
and 1997, respectively. Sales of the Company's products by distributors,
primarily the Company's Japanese distributor, accounted for 14%, 14% and 8% of
the Company's product revenues in 1995, 1996 and 1997, respectively. The loss
of one or more major third-party distributors, OEMs or resellers of the
Company's products, a significant decline in their sales, or difficulty on the
part of such third-party developers or resellers in developing successful G2-
based products and applications could have a material adverse effect on the
Company's business, results of operations, or financial condition. There can
be no assurance that the Company will be able to attract or retain additional
qualified third-party resellers or that third-party resellers will be able to
effectively sell and implement the Company's products. In addition, the
Company relies on third-party resellers to provide post-sales service and
support to its customers, and any deficiencies in such service and support
could adversely affect the Company's business, results of operations, or
financial condition.
 
  Risks Associated With International Operations. The Company's international
revenues represented 44%, 42% and 46% of total revenues in 1995, 1996, and
1997, respectively. Revenues are categorized by the Company according to
product shipment destination and therefore do not necessarily reflect the
ultimate country of installation. The international portion of the Company's
business is subject to a number of inherent risks, including difficulties in
building and managing international operations, difficulties in localizing
products and translating documentation into local languages, fluctuations in
the value of international currencies, fluctuating import/export duties and
quotas, and unexpected regulatory, economic, or political changes in
international markets. There can be no assurance that these factors will not
adversely affect the Company's business, results of operations, or financial
condition.
 
  Competition. Although the Company believes that there are no other
commercially available products that offer the full range of high-level
capabilities embodied in the Company's products, a number of companies offer
products that perform certain functions of G2 for specific applications.
Moreover, there are commercially available software development tools that
software application developers or potential customers could use to build
software having functionality similar to the Company's products. In all of the
Company's markets, competition includes "point solutions", real-time and
expert system products and internally developed software.
 
                                      29
<PAGE>
 
  Certain companies such as Objective Systems Integrators, Inc. and Pavilion
sell "point solutions" that compete with the Company's products with respect
to specific applications or uses. In addition, the Company's software is
integrated into industry-specific solutions by value-added resellers. A number
of software companies offer products that compete in specific application
areas addressed by these value-added resellers, such as cement kiln control
and refinery scheduling, and they could be successful in supplying
alternatives to products based on the Company's software.
 
  Several companies including Comdale Technologies and Ilog S.A. offer
products with limited real-time or expert system development capabilities at
lower price points than those provided by the Company. These products often
require extensive programming with languages such as C or C++ for complete
implementation. Although the Company believes that these products offer a less
productive development environment than G2 and that they lack the
comprehensive capabilities of G2-based products, certain competitors in this
category have greater financial and other resources than the Company and might
introduce new or improved products to compete with G2, possibly at lower
prices.
 
  Many of the Company's customers have significant investments in their
existing solutions and have the resources necessary to enhance existing
products and to develop future products. These customers may develop and
incorporate competing technologies into their systems or may outsource
responsibility for such systems to others who do not use the Company's
products. There is no assurance that the Company can successfully persuade
development personnel within these customers' organizations to use G2-based
products that can cost effectively compete with their internally developed
products. This would reduce the need for the Company's products and services
and limit future opportunities for the Company.
 
  The Company believes that continued investment in research and development
and sales and marketing will be required to maintain its competitive position.
There can be no assurance that competitors will not develop products or
provide services that are superior to the Company's products or services or
achieve greater market acceptance. Competitive pressures faced by the Company
could force the Company to reduce its prices, which could result in reduced
profitability. There can be no assurance that the Company will be able to
compete successfully against current and future sources of competition or that
such competition will not have a material adverse effect on the Company's
business, results of operations, or financial condition.
 
  Potential for Undetected Errors. Complex software products such as those
offered by the Company may contain unintended errors or failures commonly
referred to as "bugs". There can be no assurance that, despite significant
testing by the Company and by current and potential customers, errors will not
be found in new products after commencement of commercial shipments. Although
the Company has not experienced material adverse effects resulting from any
such errors or defects to date, there can be no assurance that errors or
defects will not be discovered in the future that could cause delays in
product introduction and shipments or require design modifications that could
adversely affect the Company's business, results of operations, or financial
condition.
 
  Dependence Upon Proprietary Technology. The Company's success is heavily
dependent upon its proprietary technology. The Company relies upon a
combination of trade secret, contract, copyright, patent, and trademark law to
protect its proprietary rights in its products and technology. The Company
enters into confidentiality and/or license agreements with its employees,
third-party resellers, and end-users and limits access to and distribution of
its software, documentation, and other proprietary information. In addition,
the Company has placed technical inhibitors in its software that prevent such
software from running on unauthorized computers. However, effective patent,
copyright, and trade secret protection may not be available in every country
in which the Company's products are distributed. There can be no assurance
that the steps taken by the Company to protect its proprietary technology will
be adequate to prevent misappropriation of its technology by third parties, or
that third parties will not be able to develop similar technology
independently. In addition, there can be no assurance that third parties will
not assert infringement claims in the future or that such claims will not be
successful.
 
                                      30
<PAGE>
 
  Dependence on Key Personnel. The Company's success depends in large part
upon certain key employees, including its executive officers, the loss of any
of whom could have a material adverse effect on the Company. In particular,
the Company hired three new executive officers in 1997, resulting in a
significant percentage of key personnel having less than one year of
experience with the Company. The Company's key employees are not bound by
employment agreements that require them to remain with the Company. The
Company's success will depend in significant part upon its ability to attract
and retain highly-skilled management, technical, and sales and marketing
personnel. Competition for such personnel in the software industry is intense,
and there can be no assurance that the Company will be successful in
attracting and retaining such personnel, or that new key personnel will
integrate successfully into the senior management team. The loss of certain
key employees or the Company's inability to attract and retain other qualified
employees or to adequately replace key personnel who depart the Company could
have a material adverse effect on the Company's business, results of
operations, or financial condition.
 
  Year 2000 Compliance. Many installed computer systems and software products
are coded to accept only two digit entries in the date code field. Beginning
in the year 2000, these date code fields will need to accept four digit
entries to distinguish 21st century dates from 20th century dates. Systems
that do not properly recognize such information could generate erroneous data
or cause a system to fail. Although the Company believes that its products and
systems are Year 2000 compliant, the Company utilizes third party equipment
and software that may not be Year 2000 compliant. Failure of such third party
equipment or software to operate properly with regard to the Year 2000 and
thereafter could require the Company to incur unanticipated expenses to remedy
any problems, which could have a material adverse affect on the Company's
business, operating results and financial condition. Furthermore, the
purchasing patterns of customers or potential customers may be affected by
Year 2000 issues as companies expend significant resources to correct their
current systems for Year 2000 compliance. These expenditures may result in
reduced funds available to purchase products and services such as those
offered by the Company.
 
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
 
  Not applicable.
 
                                      31
<PAGE>
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                      ------------------------
                                                         1997         1996
                                                      -----------  -----------
                       ASSETS
<S>                                                   <C>          <C>
Current Assets:
  Cash and cash equivalents.......................... $10,958,102  $11,678,903
  Short-term investments.............................   4,843,247    7,910,949
  Accounts receivable, less reserves of $354,000 in
   1997 and $453,000 in 1996.........................   8,310,838    9,735,914
  Prepaid expenses...................................   1,565,099    1,754,309
  Deferred income taxes..............................   1,160,276    1,578,869
                                                      -----------  -----------
    Total current assets.............................  26,837,562   32,658,944
                                                      -----------  -----------
Property and Equipment, at cost
  Computer equipment and software....................   7,373,221    6,749,039
  Furniture and fixtures.............................   1,697,510    1,540,013
  Leasehold improvements.............................     407,247      322,797
                                                      -----------  -----------
                                                        9,477,978    8,611,849
Less accumulated depreciation and amortization.......  (7,093,939)  (5,970,845)
                                                      -----------  -----------
                                                        2,384,039    2,641,004
                                                      -----------  -----------
Long-term investments................................   1,040,855      742,175
Long-term deferred income taxes......................   1,000,000          --
Deposits and other assets............................     254,651      215,498
                                                      -----------  -----------
                                                      $31,517,107  $36,257,621
                                                      ===========  ===========
<CAPTION>
        LIABILITIES AND STOCKHOLDERS' EQUITY
<S>                                                   <C>          <C>
Current Liabilities:
  Accounts payable................................... $   914,002  $ 1,262,273
  Accrued expenses...................................   4,975,813    5,109,359
  Deferred revenue...................................   5,798,927    5,817,534
                                                      -----------  -----------
Total current liabilities............................  11,688,742   12,189,166
                                                      -----------  -----------
Commitments (Note 5)
Stockholders' Equity:
  Preferred stock, authorized--2,000,000 shares......         --           --
  Common stock, $.01 par value Authorized--20,000,000
   shares
  Issued and outstanding--6,409,397 shares in 1997
   and 6,190,317 in 1996.............................      64,094       61,903
  Capital in excess of par value.....................  19,940,717   18,727,438
  Retained earnings..................................     386,878    5,355,641
  Cumulative translation adjustment..................    (563,324)     (76,527)
                                                      -----------  -----------
    Total stockholders' equity.......................  19,828,365   24,068,455
                                                      -----------  -----------
                                                      $31,517,107  $36,257,621
                                                      ===========  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       32
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                 YEAR ENDED DECEMBER 31,
                                           -------------------------------------
                                              1997         1996         1995
                                           -----------  -----------  -----------
<S>                                        <C>          <C>          <C>
REVENUES:
  Product................................  $18,433,520  $21,358,295  $16,438,400
  Service................................   17,075,603   15,877,240   11,702,577
                                           -----------  -----------  -----------
    Total revenues.......................   35,509,123   37,235,535   28,140,977
                                           -----------  -----------  -----------
COST OF REVENUES.........................    9,352,348    7,385,215    5,314,654
                                           -----------  -----------  -----------
Gross profit.............................   26,156,775   29,850,320   22,826,323
                                           -----------  -----------  -----------
OPERATING EXPENSES:
  Sales and marketing....................   18,802,113   17,432,861   14,568,045
  Research and development...............    6,977,143    5,983,741    5,267,461
  General and administrative.............    4,528,147    3,699,254    2,619,103
  Restructuring charge...................    1,557,253          --           --
                                           -----------  -----------  -----------
    Total operating expenses.............   31,864,656   27,115,856   22,454,609
                                           -----------  -----------  -----------
Operating income (loss)..................   (5,707,881)   2,734,464      371,714
OTHER INCOME:
  Interest income........................      590,659      607,761      220,493
  Other income (expense).................      188,459      (90,003)      15,537
                                           -----------  -----------  -----------
    Total other income, net..............      779,118      517,758      236,030
                                           -----------  -----------  -----------
Income (loss) before provision for income
 taxes...................................   (4,928,763)   3,252,222      607,744
PROVISION FOR INCOME TAXES...............       40,000    1,204,000      411,000
                                           -----------  -----------  -----------
Net income (loss)........................  $(4,968,763) $ 2,048,222  $   196,744
                                           ===========  ===========  ===========
Basic income (loss) per share............  $     (0.79) $      0.35  $      0.05
                                           ===========  ===========  ===========
Diluted income (loss) per share..........  $     (0.79) $      0.33  $      0.04
                                           ===========  ===========  ===========
Weighted average common shares
 outstanding.............................    6,309,815    5,909,511    3,993,600
                                           ===========  ===========  ===========
Weighted average common shares outstand-
 ing assuming dilution...................    6,309,815    6,286,170    4,762,245
                                           ===========  ===========  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       33
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                              SERIES A            SERIES B
                            CONVERTIBLE         CONVERTIBLE
                          PREFERRED STOCK     PREFERRED STOCK        COMMON STOCK
                         ------------------- -------------------  -------------------
                          NUMBER              NUMBER
                            OF       $0.10      OF       $0.10    NUMBER OF   $0.01
                          SHARES   PAR VALUE  SHARES   PAR VALUE   SHARES   PAR VALUE
                         --------  --------- --------  ---------  --------- ---------
<S>                      <C>       <C>       <C>       <C>        <C>       <C>
BALANCE, DECEMBER 31,
 1994...................  300,000   $30,000   353,460  $ 35,346   3,993,600  $39,936
  Exercise of stock
   options..............      --        --        --        --        7,400       74
  Translation
   adjustment...........      --        --        --        --          --       --
  Net income............      --        --        --        --          --       --
BALANCE, DECEMBER 31,
 1995...................  300,000    30,000   353,460    35,346   4,001,000   40,010
  Conversion of Series A
   convertible preferred
   stock into common
   stock................ (300,000)  (30,000)      --        --      300,000    3,000
  Conversion of Series B
   convertible preferred
   stock into common
   stock................      --        --   (353,460)  (35,346)    353,460    3,534
  Issuance of common
   stock from Initial
   Public Offering, net
   of issuance costs of
   $758,737.............      --        --        --        --    1,366,788   13,668
  Exercise of stock
   options..............      --        --        --        --      134,900    1,349
  Issuance of common
   stock under Employee
   Stock Purchase Plan
   (ESPP)...............      --        --        --        --       34,169      342
  Tax benefit from
   exercise of incentive
   stock options and
   shares purchased
   under ESPP...........      --        --        --        --          --       --
  Translation
   adjustment...........      --        --        --        --          --       --
    Net income..........      --        --        --        --          --       --
                         --------   -------  --------  --------   ---------  -------
BALANCE, DECEMBER 31,
 1996...................      --        --        --        --    6,190,317   61,903
  Exercise of stock
   options..............      --        --        --        --       91,170      912
  Issuance of common
   stock under ESPP.....      --        --        --        --      127,910    1,279
  Translation
   adjustment...........      --        --        --        --          --       --
  Tax benefit from
   exercise of incentive
   stock options and
   shares purchased
   under ESPP...........      --        --        --        --          --       --
  Net loss..............      --        --        --        --          --       --
                         --------   -------  --------  --------   ---------  -------
BALANCE, DECEMBER 31,
 1997...................      --        --        --        --    6,409,397  $64,094
                         ========   =======  ========  ========   =========  =======
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       34
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
          CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY--(CONTINUED)
 
<TABLE>
<CAPTION>
                              CAPITAL IN              CUMULATIVE      TOTAL
                               EXCESS OF   RETAINED   TRANSLATION STOCKHOLDERS'
                               PAR VALUE   EARNINGS   ADJUSTMENT     EQUITY
                              ----------- ----------  ----------- -------------
<S>                           <C>         <C>         <C>         <C>
BALANCE, DECEMBER 31, 1994... $ 5,204,989 $3,110,675   $ (60,702)  $ 8,360,244
  Exercise of stock options..      28,966        --          --         29,040
  Translation adjustment.....         --         --       24,549        24,549
  Net income.................         --     196,744         --        196,744
                              ----------- ----------   ---------   -----------
BALANCE, DECEMBER 31, 1995...   5,233,955  3,307,419     (36,153)    8,610,577
  Conversion of Series A
   convertible preferred
   stock into common stock...      27,000        --          --            --
  Conversion of Series B
   convertible preferred
   stock into common stock...      31,812        --          --            --
  Issuance of common stock
   from Initial Public
   Offering, net of issuance
   costs of $758,737.........  11,938,723        --          --     11,952,391
  Exercise of stock options..     611,541        --          --        612,890
  Issuance of common stock
   under Employee Stock
   Purchase Plan (ESPP)......     326,407        --          --        326,749
  Tax benefit from exercise
   of incentive stock options
   and shares purchased under
   ESPP......................     558,000        --          --        558,000
  Translation adjustment.....         --         --      (40,374)      (40,374)
  Net income.................         --   2,048,222         --      2,048,222
                              ----------- ----------   ---------   -----------
BALANCE, DECEMBER 31, 1996...  18,727,438 $5,355,641     (76,527)   24,068,455
  Exercise of stock options..     500,039        --          --        500,951
  Issuance of common stock
   under ESPP................     631,833        --          --        633,112
  Translation adjustment.....         --         --     (486,797)     (486,797)
  Tax benefit from exercise
   of incentive stock options
   and shares purchased under
   ESPP......................      81,407        --          --         81,407
  Net loss...................         --  (4,968,763)        --     (4,968,763)
                              ----------- ----------   ---------   -----------
BALANCE, DECEMBER 31, 1997... $19,940,717 $  386,878   $(563,324)  $19,828,365
                              =========== ==========   =========   ===========
</TABLE>
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       35
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                               YEAR ENDED DECEMBER 31,
                                         -------------------------------------
                                            1997         1996         1995
                                         -----------  -----------  -----------
<S>                                      <C>          <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)......................  $(4,968,763) $ 2,048,222  $   196,744
Adjustments to reconcile net income
 (loss) to net cash provided by (used
 in) operating activities:
  Depreciation and amortization........    1,147,112    1,087,658      959,109
  Deferred income taxes................     (500,000)    (637,325)    (724,788)
  Restructuring charge.................      842,251          --           --
  Changes in assets and liabilities:
    Accounts receivable................    1,375,274   (1,481,427)  (3,113,369)
    Prepaid expenses...................       15,845     (691,719)    (659,872)
    Accounts payable...................     (314,597)     242,060      414,545
    Accrued expenses...................     (490,261)   1,902,329    1,920,121
    Deferred revenue...................      (10,556)   1,398,857      876,153
                                         -----------  -----------  -----------
    Net cash provided by (used in)
     operating activities..............   (2,903,695)   3,868,655     (131,357)
                                         -----------  -----------  -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Sales (purchases) of short-term
   investments.........................    3,067,702   (4,945,007)  (2,965,942)
  Purchases of long-term investments...     (298,680)    (742,175)         --
  Purchases of property and equipment..   (1,187,042)  (1,562,217)  (1,610,019)
  Decrease (increase) in deposits and
   other assets........................      (80,330)      37,391       (4,307)
                                         -----------  -----------  -----------
    Net cash provided by (used in)
     investing activities..............    1,501,650   (7,212,008)  (4,580,268)
                                         -----------  -----------  -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from exercise of stock
   options.............................      500,951      612,890       29,040
  Proceeds from issuance of common
   stock under employee stock purchase
   plan................................      633,112      326,749          --
  Proceeds from initial public
   offering, net of issuance costs.....          --    11,952,391          --
                                         -----------  -----------  -----------
    Net cash provided by financing
     activities........................    1,134,063   12,892,030       29,040
                                         -----------  -----------  -----------
EFFECT OF EXCHANGE RATE CHANGES ON
 CASH..................................     (452,819)       3,967       36,173
                                         -----------  -----------  -----------
NET INCREASE (DECREASE) IN CASH AND
 CASH EQUIVALENTS......................     (720,801)   9,552,644   (4,646,412)
CASH AND CASH EQUIVALENTS, BEGINNING OF
 PERIOD................................   11,678,903    2,126,259    6,772,671
                                         -----------  -----------  -----------
CASH AND CASH EQUIVALENTS, END OF
 PERIOD................................  $10,958,102  $11,678,903  $ 2,126,259
                                         ===========  ===========  ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
 INFORMATION:
  Cash paid during the period for--
    Income taxes.......................  $   445,242  $   608,805  $   586,801
                                         ===========  ===========  ===========
    Interest...........................  $       --   $       --   $    10,032
                                         ===========  ===========  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       36
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
(1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
 
  The Company is a leading supplier of software products and services for
developing and deploying intelligent systems that manage and improve complex,
dynamic operations for a broad range of industrial, scientific, commercial,
and government applications.
 
  The accompanying consolidated financial statements reflect the application
of certain significant accounting policies, as described in this note and
elsewhere in the accompanying consolidated financial statements and notes.
 
  (A) PRINCIPLES OF CONSOLIDATION
 
  The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries. All material intercompany
transactions and balances have been eliminated in consolidation.
 
  (B) CASH EQUIVALENTS AND INVESTMENTS
 
  The Company accounts for investments under Statement of Financial Accounting
Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and
Equity Securities. The Company's investments are classified as available-for-
sale and are recorded at fair value, which approximates amortized cost at
December 31, 1997. Cash equivalents are short-term, highly liquid investments
with original maturity dates of less than three months. Short-term investments
held as of December 31, 1997 consist of municipal bonds with original maturity
dates greater than three months that mature within one year. Long-term
investments held as of December 31, 1997 consist of municipal bonds with
maturity dates of greater than one year.
 
  (C) DEPRECIATION AND AMORTIZATION
 
  The Company provides for depreciation and amortization using the straight-
line method by charges to operations in amounts that allocate the cost of the
assets over their estimated useful lives as follows:
 
<TABLE>
<CAPTION>
                                                                   ESTIMATED
       ASSET CLASSIFICATION                                       USEFUL LIVES
       --------------------                                      --------------
       <S>                                                       <C>
       Computer equipment and software..........................  3 Years
       Furniture and fixtures...................................  5 Years
       Leasehold improvements...................................  Life of lease
</TABLE>
 
  (D) REVENUE RECOGNITION
 
  Product revenues are recognized upon shipment or upon the completion of all
significant obligations by the Company, whichever is later. Revenue from the
sale of multicopy licenses is recognized upon the shipment of the product
master or the first copy of the software product if the product master is not
to be delivered. The Company recognizes service revenues from consulting and
training upon performance of the services. Software maintenance fees are
recognized as revenue ratably over the period to which they relate. Deferred
revenue represents primarily advance billings for software services, which
include maintenance, consulting, training and license prepayment fees.
 
  In October 1997, the American Institute of Certified Public Accountants
issued Statement of Position 97-2 ("SOP 97-2"), Software Revenue Recognition.
The Company intends to adopt this pronouncement in fiscal 1998, as required by
SOP 97-2. The Company believes that its current revenue recognition practices
are consistent with those required by SOP 97-2.
 
  (E) RESEARCH AND DEVELOPMENT AND SOFTWARE DEVELOPMENT COSTS
 
  In accordance with SFAS No. 86, Accounting for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed, the Company has evaluated
the establishment of technological feasibility of its various
 
                                      37
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
products during the development phase. Due to the dynamic changes in the
market, the Company has concluded that it cannot determine technological
feasibility until the development phase of the project is nearly complete. The
time period during which costs could be capitalized from the point of reaching
technological feasibility until the time of general product release is very
short and, consequently, the amounts that could be capitalized are not
material to the Company's financial position or results of operations.
Therefore, the Company charges all research and development expenses to
operations in the period incurred.
 
  (F) FOREIGN CURRENCY TRANSLATION
 
  Assets and liabilities of the foreign subsidiaries are translated in
accordance with SFAS No. 52, Foreign Currency Translation. In accordance with
SFAS No. 52, assets and liabilities of the Company's foreign operations are
translated into U.S. dollars at current exchange rates, and income and expense
items are translated at average rates of exchange prevailing during the year.
Gains and losses arising from translation are accumulated as a separate
component of stockholders' equity. Gains and losses arising from transactions
denominated in foreign currencies are included in other income and were not
material for the periods presented.
 
  (G) RETIREMENT PLAN
 
  Effective January 1997, the Company amended the Gensym Corporation 401(k)
Plan (the "Plan") to allow for employer matching contributions. The Company
has elected to contribute an amount equal to 50% of the first 4%, and 25% of
the next 4% of an employee's compensation (as defined) contributed to the Plan
as an elective deferral. The Company's contributions to the Plan were $314,000
for the year ended December 31, 1997. There were no contributions for the
years ended December 31, 1996 or 1995.
 
  (H) CONCENTRATION OF CREDIT RISK
 
  SFAS No. 105, Disclosure of Information about Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with Concentration of Credit
Risk, requires disclosure of any significant off-balance-sheet and credit risk
concentrations. Financial instruments, which potentially subject the Company
to concentrations of credit risk, are principally cash, cash equivalents,
investments and accounts receivable. The Company places its cash, cash
equivalents and investments in highly rated institutions. No single customer
accounted for greater than 10% of total revenues or represented a significant
credit risk to the Company in either 1997 or 1996. As of December 31, 1997, no
single customer accounted for greater than 10% of accounts receivable. As of
December 31, 1996, one customer accounted for approximately 12% of accounts
receivable. The Company has no significant off-balance-sheet concentration of
credit risk such as foreign exchange contracts, options contracts, or other
foreign hedging arrangements.
 
  (I) INCOME (LOSS) PER SHARE
 
  During the year, the Company adopted SFAS No. 128, Earnings per Share. As a
result, all previous reported earnings per share have been restated. Basic
income (loss) per share was computed by dividing net income (loss) by the
weighted average number of common shares outstanding during the periods.
Diluted income (loss) per share was computed using the weighted average number
of common and common equivalent shares outstanding during the periods in
accordance with the treasury stock method. For the year ended December 31,
1997, the computation for diluted loss per share excludes the effect of 81,872
shares issuable from assumed exercise of options, as their effect would be
antidilutive. For the year ended December 31, 1995, the computation for
diluted income per share assumes that all series of Convertible Preferred
Stock had been converted to common stock as of the original issuance dates.
 
                                      38
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Basic and diluted income (loss) per share were calculated as follows:
 
<TABLE>
<CAPTION>
                                                1997         1996       1995
                                             -----------  ---------- ----------
<S>                                          <C>          <C>        <C>
BASIC
Net income (loss)........................... $(4,968,763) $2,048,222 $  196,744
                                             -----------  ---------- ----------
Weighted average common shares outstanding..   6,309,815   5,909,511  3,993,600
                                             -----------  ---------- ----------
Basic income (loss) per share............... $     (0.79) $     0.35 $     0.05
                                             ===========  ========== ==========
DILUTED
Net income (loss)........................... $(4,968,763) $2,048,222 $  196,744
                                             -----------  ---------- ----------
Weighted average common shares outstanding..   6,309,815   5,909,511  3,993,600
Effect of:
  Assumed exercise of stock options.........         --      376,659    115,185
  Assumed conversion of convertible
   preferred stock..........................         --          --     653,460
                                             -----------  ---------- ----------
Weighted average common shares outstanding,
 assuming dilution..........................   6,309,815   6,286,170  4,762,245
                                             -----------  ---------- ----------
Diluted income (loss) per share............. $     (0.79) $     0.33 $     0.04
                                             ===========  ========== ==========
</TABLE>
 
  (J) USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
  (K) RECLASSIFICATION
 
  Certain balances have been reclassified to conform with current year
presentation.
 
(2) LINE OF CREDIT
 
  The Company has a working capital line of credit with a bank under which
borrowings and/or letters of credit are limited to $1,000,000. The line of
credit is unsecured, and borrowings bear interest at the prime rate (8.5% as
of December 31, 1997). The line of credit expires on May 31, 1998. As of
December 31, 1997 there were no borrowings outstanding under the line of
credit. Under this credit facility, the Company is required to comply with
certain financial ratios, including minimum levels of net worth and
profitability. The Company obtained a waiver from the bank with respect to the
Company's failure to satisfy the profitability covenant as of December 31,
1997.
 
(3) STOCKHOLDERS' EQUITY
 
  (A) INITIAL PUBLIC OFFERING
 
  In February 1996, the Company sold, through an underwritten public offering,
1,200,000 shares of its common stock at $10 per share. Also in February 1996,
the Company sold an additional 166,788 shares, at $10 per share, pursuant to
an underwriters' over-allotment provision. The Company received proceeds of
$11,952,381 from its initial public offering which are net of issuance costs
of $758,737.
 
  (B) COMMON STOCK
 
  On January 16, 1996, the stockholders increased the Company's authorized
capitalization to 20,000,000 shares of common stock and 2,000,000 shares of
preferred stock.
 
                                      39
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  (C) SERIES A AND SERIES B CONVERTIBLE PREFERRED STOCK
 
  The Series A and Series B convertible preferred stock were converted into
common shares upon the closing of the Company's initial public offering in
February 1996.
 
  (D) STOCK OPTION PLANS
 
  Through December 31, 1997, the Company maintained four stock option plans.
The Board of Directors has resolved not to grant any more options under the
1987 Stock Plan. The 1994 Stock Option Plan provides for the grant of
incentive stock options and nonqualified stock options. The Company is
authorized to award up to 534,850 stock options under this plan. The 1997
Stock Option Plan provides for the grant of incentive stock options,
nonqualified stock options, restricted stock and other stock-based awards. The
Company is authorized to award up to 500,000 stock options under this plan.
Under these plans, incentive stock options may be granted at an exercise price
not less than the fair market value of the Company's common stock on the date
of grant or, in the case of 10% stockholders, not less than 110% of the fair
market value, as determined by the Board of Directors. Nonqualified options
may be granted by the Board of Directors at its discretion. The difference, if
any, between the exercise price and the fair value of the underlying common
stock at the measurement date is charged to operations over the vesting period
of such options. The terms of exercise of options granted under these plans
are determined by the Board of Directors. Incentive stock options expire no
later than 10 years after the date of grant.
 
  The 1995 Director Stock Option Plan (the "Director Plan") was approved by
the stockholders in January 1996 and amended in May 1997. The Director Plan
provides for the grant of options to purchase a maximum of 100,000 shares of
common stock of the Company to non-employee directors of the Company. Upon
completion of the Company's initial public offering of the Company's common
stock, each non-employee director was granted an option under the Director
Plan to purchase 2,000 shares of common stock at the initial public offering
price. On June 30 of each year, beginning in 1997, each non-employee director
will be granted an option to purchase 3,000 shares of common stock at an
exercise price equal to the last reported sale price of the Company's common
stock on the Nasdaq National Market on the date of grant. Such options vest in
equal portions over a five year period and expire 10 years from the date of
grant.
 
  The following schedule summarizes the stock option activity under all four
option plans for the three years ended December 31, 1997:
 
<TABLE>
<CAPTION>
                                              NUMBER
                                                OF     OPTION PRICE  WTD. AVG.
                                              SHARES    PER SHARE   OPTION PRICE
                                             --------  ------------ ------------
<S>                                          <C>       <C>          <C>
Outstanding at December 31, 1994............  477,100  $ 1.60-$7.50    $ 5.71
Granted.....................................  227,750          7.50      7.50
Exercised...................................   (7,400)    3.00-7.50      3.95
Canceled....................................  (35,600)    3.00-7.50      6.93
                                             --------  ------------    ------
Outstanding at December 31, 1995............  661,850     1.60-7.50      6.30
Granted.....................................  251,000   10.00-21.25     17.49
Exercised................................... (134,900)    1.60-7.50      4.54
Canceled.................................... (193,890)   7.50-21.25     14.20
                                             --------  ------------    ------
Outstanding at December 31, 1996............  584,060    1.60-20.00      8.73
Granted.....................................  572,620    4.50-11.75      6.08
Exercised...................................  (91,170)    1.60-7.50      5.49
Canceled.................................... (245,730)   4.88-20.00     10.71
                                             --------  ------------    ------
Outstanding at December 31, 1997............  819,780  $1.60-$20.00    $ 6.65
                                             ========  ============    ======
Exercisable at December 31, 1997............  179,140  $1.60-$20.00    $ 6.84
                                             ========  ============    ======
</TABLE>
 
 
                                      40
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Company's 1995 Employee Stock Purchase Plan (the "Purchase Plan") was
adopted by the Board of Directors in November 1995 and approved by the
stockholders in January 1996. The Purchase Plan authorizes the sale of up to a
total of 200,000 shares of common stock to participating employees.
 
  All employees of the Company meeting certain eligibility requirements are
eligible to participate in the Purchase Plan. An employee may elect to have a
whole number percentage from 1% to 10% of his or her base pay withheld during
the payroll deduction period (Offering Period) for purposes of purchasing
shares under the Purchase Plan. The price at which shares may be purchased
during each offering will be 85% of the fair market value per share of the
common stock on either the first day or the last day of the Offering Period,
whichever is lower. The Compensation Committee of the Board of Directors may,
at its discretion, choose an Offering Period of 12 months or less for each of
the offerings and choose a different Offering Period for each offering. Under
the Purchase Plan, the Company had sold 162,079 shares as of December 31,
1997. As of December 31, 1997, 37,921 shares of common stock were available
for future sale under the Purchase Plan.
 
  (E) STOCK-BASED COMPENSATION
 
  The Company has computed the pro forma disclosure required under SFAS No.
123 for all stock compensation plans during the years ended December 31, 1997
and 1996 using the Black-Scholes option pricing model under the fair value
method prescribed by SFAS No. 123. The assumptions used are as follows:
 
<TABLE>
<CAPTION>
                                                              1997       1996
                                                           ---------- ----------
   <S>                                                     <C>        <C>
   Risk-free interest rate................................ 5.46-6.71% 5.47-6.88%
   Expected dividend yield................................          0          0
   Expected lives of option grants........................  6.5 Years  6.5 Years
   Expected volatility....................................        63%        65%
</TABLE>
 
  For the purposes of pro forma disclosure, the estimated fair value of
options is amortized to expense over the vesting period. Had compensation
costs for options and Purchase Plan shares been determined based on the fair
value at the grant dates as prescribed by SFAS No. 123, the effect would have
been as follows:
 
<TABLE>
<CAPTION>
                                                           1997         1996
                                                        -----------  ----------
   <S>                                                  <C>          <C>
   Net income (loss) as reported....................... $(4,968,763) $2,048,222
   Pro forma net income (loss) as adjusted.............  (5,615,312)  1,736,170
   Diluted income (loss) per share as reported......... $     (0.79) $     0.33
   Pro forma diluted income (loss) per share as
    adjusted........................................... $     (0.95) $     0.28
</TABLE>
 
  The estimated weighted average fair value of options granted during 1997 and
1996 was $3.95 and $8.48 per share, respectively. The estimated weighted
average fair value of grants made under the Purchase Plan during 1997 and 1996
was $1.99 and $3.97, respectively, computed using the assumptions described
above with an expected life of six months for the option feature present in
the Purchase Plan awards. At December 31, 1997, the weighted average remaining
life of outstanding stock options was 7.32 years.
 
                                      41
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
(4) INCOME TAXES
 
  The components of the provision for income taxes for the three years ended
December 31, 1997 are as follows:
 
<TABLE>
<CAPTION>
                                               1997         1996        1995
                                            -----------  ----------  ----------
   <S>                                      <C>          <C>         <C>
   Federal
     Current............................... $   (90,638) $  758,694  $   25,000
     Deferred..............................  (2,221,471)   (122,463)   (565,400)
                                            -----------  ----------  ----------
                                             (2,312,109)    636,231    (540,400)
                                            -----------  ----------  ----------
   State
     Current...............................       6,428     252,898         --
     Deferred..............................     (27,620)    (40,821)    (23,439)
                                            -----------  ----------  ----------
                                                (21,192)    212,077     (23,439)
                                            -----------  ----------  ----------
   Foreign
     Withholding...........................     181,617     443,000     386,541
     Income................................     524,000     386,733     751,109
                                            -----------  ----------  ----------
                                                705,617     829,733   1,137,650
                                            -----------  ----------  ----------
   Change in Valuation Allowance...........   1,667,684    (474,041)   (162,811)
                                            -----------  ----------  ----------
                                            $    40,000  $1,204,000  $  411,000
                                            ===========  ==========  ==========
</TABLE>
 
  Foreign withholding taxes represent amounts withheld by foreign customers
and remitted to the applicable foreign tax authorities in connection with
foreign revenues. Foreign income taxes represent corporate income taxes
relating to the operations of the Company's foreign subsidiaries.
 
  The components of the net deferred tax asset recognized in the accompanying
consolidated balance sheets with the approximate income tax effect of each
type of temporary difference are as follows:
 
<TABLE>
<CAPTION>
                                                            1997         1996
                                                         -----------  ----------
   <S>                                                   <C>          <C>
   Net operating loss carryforward...................... $ 2,138,450  $   47,153
   Research and development tax credit carryforward.....     715,871     697,889
   Depreciation.........................................     136,500      58,500
   Deferred revenue.....................................     451,984     220,350
   Other temporary differences..........................     385,155     554,977
                                                         -----------  ----------
                                                           3,827,960   1,578,869
   Valuation allowance..................................  (1,667,684)        --
                                                         -----------  ----------
   Net deferred tax asset............................... $ 2,160,276  $1,578,869
                                                         ===========  ==========
</TABLE>
 
  The net operating loss carryforwards expire on various dates through 2012
and are subject to review and possible adjustment by the Internal Revenue
Service.
 
  The Internal Revenue Code contains provisions that may limit the net
operating loss and credit carryforwards that the Company may utilize in any
one year in the event of certain cumulative changes in ownership over a three
year period. In the event that the Company has had a change in ownership, as
defined, utilization of the carryforwards may be restricted.
 
  The Company has established a valuation allowance against its deferred tax
asset to the extent that it cannot conclusively demonstrate that these assets
"more likely than not" will be realized.
 
                                      42
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The provision for income taxes differs from the amount computed by applying
the statutory federal income tax rate as follows:
 
<TABLE>
<CAPTION>
                                                           1997    1996   1995
                                                           -----   -----  -----
       <S>                                                 <C>     <C>    <C>
       Provision at federal statutory rate................ (34.0)%  34.0%  34.0%
       State income tax, net of federal benefits..........  (0.3)    4.3   (2.5)
       Foreign income and withholding taxes...............   6.6    19.6   82.3
       Change in valuation allowance......................  33.8   (14.6) (26.8)
       Utilization of tax credits.........................  (0.4)   (9.5) (16.4)
       Other, net.........................................  (4.9)    3.2   (3.0)
                                                           -----   -----  -----
                                                             0.8 %  37.0%  67.6%
                                                           =====   =====  =====
</TABLE>
 
(5) COMMITMENTS
 
  The Company leases its facilities and certain equipment under operating
leases. The future minimum annual payments under these leases at December 31,
1997 are as follows:
 
<TABLE>
<CAPTION>
       YEAR                                                             AMOUNT
       ----                                                           ----------
       <S>                                                            <C>
       1998.......................................................... $2,876,000
       1999..........................................................  2,487,000
       2000..........................................................  1,867,000
       2001..........................................................    557,000
       2002..........................................................    233,000
       Thereafter....................................................    152,000
                                                                      ----------
                                                                      $8,172,000
                                                                      ==========
</TABLE>
 
  Expenses recorded by the Company under the above leases, net of rental
income from sub-leases, for the three years ended December 31, 1997, 1996 and
1995 were approximately $3,834,000, $3,102,000, and $2,226,000, respectively.
 
(6) ACCRUED EXPENSES
 
  Accrued expenses consist of the following:
 
<TABLE>
<CAPTION>
                                                             1997       1996
                                                          ---------- ----------
       <S>                                                <C>        <C>
       Accrued payroll and related expenses.............. $1,033,397 $1,273,115
       Accrued commissions...............................    800,000  1,001,359
       Other accrued expenses............................  3,142,416  2,834,885
                                                          ---------- ----------
                                                          $4,975,813 $5,109,359
                                                          ========== ==========
</TABLE>
 
(7) RESTRUCTURING CHARGE
 
  During the second quarter of 1997, the Company recorded a charge of $2.0
million for restructuring costs associated with the reduction of its
workforce, closing and consolidation of several field sales offices and
consolidation of office space in its corporate headquarters. The charge
included accruals for rent and lease termination costs, severance and other
employee termination costs and the write off of certain assets that would
provide no future benefit to the Company as a result of the restructuring
plan. In the third quarter, the Company recorded a restructuring credit of
$485,000 for the recovery of its investment in a joint venture, a portion of
which had been written off in the previous quarter.
 
                                      43
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  As of December 31, 1997, approximately $490,000 of the accrual had not been
utilized. It is anticipated that the remaining balance will be substantially
expended by the end of the second quarter of 1998.
 
(8) FINANCIAL INFORMATION BY GEOGRAPHIC AREA
 
  Domestic and international sales as a percentage of total revenues are as
follows:
 
<TABLE>
<CAPTION>
                                                                 1997  1996  1995
                                                                 ----  ----  ----
       <S>                                                       <C>   <C>   <C>
       United States............................................  54%   58%   56%
       Europe...................................................  30    24    24
       Other....................................................  16    18    20
                                                                 ---   ---   ---
                                                                 100%  100%  100%
                                                                 ===   ===   ===
</TABLE>
 
  Revenues, net income (loss) and identifiable assets for the Company's United
States, European and other operations are as follows:
 
<TABLE>
<CAPTION>
                           UNITED
                           STATES       EUROPE      OTHER     ELIMINATIONS  CONSOLIDATED
                         -----------  ---------- -----------  ------------  ------------
<S>                      <C>          <C>        <C>          <C>           <C>
Year ended December 31,
 1997:
  Revenues.............. $34,010,493  $1,227,849 $   270,781  $       --    $35,509,123
  Transfers between
   geographic locations.     254,320   6,201,867   1,162,155   (7,618,342)          --
                         -----------  ---------- -----------  -----------   -----------
  Total revenues........ $34,264,813  $7,429,716 $ 1,432,936  $(7,618,342)  $35,509,123
                         ===========  ========== ===========  ===========   ===========
  Net income (loss)..... $(4,156,293) $  583,578 $(1,396,048) $       --    $(4,968,763)
                         ===========  ========== ===========  ===========   ===========
  Identifiable assets... $27,981,625  $2,785,696 $   749,786  $       --    $31,517,107
                         ===========  ========== ===========  ===========   ===========
Year ended December 31,
 1996:
  Revenues.............. $36,004,203  $1,125,677 $   105,655  $       --    $37,235,535
  Transfers between
   geographic locations.     271,044   5,474,003     324,359   (6,069,406)          --
                         -----------  ---------- -----------  -----------   -----------
  Total revenues........ $36,275,247  $6,599,680 $   430,014  $(6,069,406)  $37,235,535
                         ===========  ========== ===========  ===========   ===========
  Net income (loss)..... $ 2,814,838  $  414,125 $(1,180,741) $       --    $ 2,048,222
                         ===========  ========== ===========  ===========   ===========
  Identifiable assets... $33,064,227  $2,700,284 $   493,110  $       --    $36,257,621
                         ===========  ========== ===========  ===========   ===========
Year ended December 31,
 1995:
  Revenues.............. $27,184,435  $  910,006 $    46,536  $       --    $28,140,977
  Transfers between
   geographic locations.     264,624   4,756,239     302,714   (5,323,577)          --
                         -----------  ---------- -----------  -----------   -----------
  Total revenues........ $27,449,059  $5,666,245 $   349,250  $(5,323,577)  $28,140,977
                         ===========  ========== ===========  ===========   ===========
  Net income (loss)..... $   404,440  $  490,296 $  (697,992) $       --    $   196,744
                         ===========  ========== ===========  ===========   ===========
  Identifiable assets... $15,963,186  $1,520,166 $   363,143  $       --    $17,846,495
                         ===========  ========== ===========  ===========   ===========
</TABLE>
 
                                      44
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
To Gensym Corporation:
 
  We have audited the accompanying consolidated balance sheets of Gensym
Corporation (a Delaware corporation) and subsidiaries as of December 31, 1997
and 1996, and the related consolidated statements of operations, stockholder's
equity, and cash flows for each of the three years in the period ended
December 31, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Gensym Corporation and
subsidiaries as of December 31, 1997 and 1996, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting
principles.
 
                                               /s/ Arthur Andersen LLP
                                          _____________________________________
                                                   Arthur Andersen LLP
 
Boston, Massachusetts
January 23, 1998
 
                                      45
<PAGE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURES
 
  None
 
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The information required by this item is contained in part under "Executive
Officers of the Company" in Part I hereof, and the remainder is contained
under the caption "PROPOSAL 1--ELECTION OF DIRECTORS" in the Company's Proxy
Statement dated April 8, 1998, for the Annual Meeting of Stockholders to be
held on May 20, 1998 (the "Proxy Statement"). Such information is incorporated
herein by reference.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The information required by this item is contained under the captions
"Director Compensation" and "Compensation to Executive Officers" in the
Company's Proxy Statement. Such information is incorporated herein by
reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information required by this item is contained under the caption
"Security Ownership of Certain Beneficial Owners and Management" in the
Company's Proxy Statement. Such information is incorporated herein by
reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information required by this item is contained under the caption
"Certain Transactions" in the Company's Proxy Statement. Such information is
incorporated herein by reference.
 
                                      46
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
 
  (a)(1) Financial Statements
 
  The following documents are included in Item 8 of this Annual Report on Form
10-K:
 
    Consolidated Balance Sheets as of December 31, 1997 and 1996
    Consolidated Statements of Operations for the three years ended
    December 31, 1997
    Consolidated Statements of Stockholders' Equity for the three years
    ended December 31, 1997
    Consolidated Statements of Cash Flows for the three years ended
    December 31, 1997
    Notes to Consolidated Financial Statements
    Report of Independent Public Accountants
 
  (2) Financial Statement Schedules
 
  The following consolidated financial statement schedules are included in
Item 14(d):
 
    Schedule II--Valuation and Qualifying Accounts
 
  All other schedules have been omitted since the required information is not
present or not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the consolidated
financial statements or the notes thereto.
 
  (3) Exhibits
 
  The Exhibits listed in the Exhibit Index immediately preceding such Exhibits
are filed as part of this Annual Report on Form 10-K, and are incorporated
herein by reference.
 
  (b) Reports on Form 8-K
 
  No reports on Form 8-K were filed during the quarter ended December 31, 1997
 
                                      47
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
 
                                          GENSYM CORPORATION
                                          (Registrant)
 
                                               /s/  Lowell B. Hawkinson
                                          By: _________________________________
Dated: March 18, 1998                               Lowell B. Hawkinson
                                                  Chief Executive Officer
 
  Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on March 18, 1998:
 
<TABLE>
<CAPTION>
              SIGNATURE                                       TITLE
              ---------                                       -----
 
 <C>                                  <S>
    /s/  Lowell B. Hawkinson          Chairman, Chief Executive Officer, Director
 ____________________________________  (Principal Executive Officer)
         Lowell B. Hawkinson
 
      /s/  Richard M. Darer           Senior Vice President of Finance and
 ____________________________________  Administration
           Richard M. Darer            and CFO (Principal Financial and Accounting Officer)
 
      /s/  Robert L. Moore            President and Director
 ____________________________________
           Robert L. Moore
 
       /s/  John A. Shane             Director
 ____________________________________
            John A. Shane
 
      /s/  Theodore Johnson           Director
 ____________________________________
           Theodore Johnson
 
   /s/  Thomas E. Swithenbank         Director
 ____________________________________
        Thomas E. Swithenbank
</TABLE>
 
                                      48
<PAGE>
 
ITEM 14(D) FINANCIAL STATEMENT SCHEDULE
 
      REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTARY SCHEDULE
 
To Gensym Corporation:
 
  We have audited, in accordance with generally accepted auditing standards,
the consolidated financial statements of Gensym Corporation and subsidiaries
and have issued our report thereon dated January 23, 1998. Our audit was made
for the purpose of forming an opinion on those consolidated financial
statements taken as a whole. The schedule listed in the financial statement
schedule index is the responsibility of the Company's management and is
presented for the purpose of complying with the Securities and Exchange
Commission's rules and is not part of the basic consolidated financial
statements. This schedule has been subjected to auditing procedures applied in
the audit of the basic consolidated financial statements and, in our opinion,
fairly states, in all material respects, the financial data required to be set
forth therein in relation to the basic consolidated financial statements taken
as a whole.
 
                                               /s/ Arthur Andersen LLP
                                          _____________________________________
                                                   Arthur Andersen LLP
 
Boston, Massachusetts
January 23, 1998
 
                                      49
<PAGE>
 
                               GENSYM CORPORATION
 
                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
 
           FOR THE THREE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
 
<TABLE>
<CAPTION>
                                          BALANCE  ADDITION            BALANCE
                                            AT     CHARGED              AT END
                                         BEGINNING    TO                  OF
              DESCRIPTION                OF PERIOD EXPENSE  DEDUCTIONS  PERIOD
              -----------                --------- -------- ---------- --------
<S>                                      <C>       <C>      <C>        <C>
Allowance for Doubtful Accounts:
  Year ended December 31, 1997.......... $453,319  $225,000  $324,114  $354,205
                                         ========  ========  ========  ========
  Year ended December 31, 1996.......... $414,612  $124,600  $ 85,893  $453,319
                                         ========  ========  ========  ========
  Year ended December 31, 1995.......... $488,091  $    --   $ 73,479  $414,612
                                         ========  ========  ========  ========
</TABLE>
 
                                       50
<PAGE>
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
 EXHIBIT
   NO.                                 DESCRIPTION
 -------                               -----------
 <C>     <S>
  3.1    Amended and Restated Certificate of Incorporation of the Registrant
          (Incorporated by reference to the Registrant's Annual Report on Form
          10-K filed on March 31, 1997)
  3.2    Amended and Restated By-Laws of the Registrant (Incorporated by
          reference to the Registrant's Annual Report on Form 10-K filed on
          March 31, 1997)
  4.1    Specimen certificate for shares of the Registrant's Common Stock
          (Incorporated by reference to the Registration Statement on Form S-1
          of the Registrant filed on December 21, 1995)
 10.1    1987 Stock Plan, as amended to date (Incorporated by reference to the
          Registration Statement on Form S-1 of the Registrant filed on
          December 21, 1995)
 10.2    1994 Stock Option Plan (Incorporated by reference to the Registration
          Statement on Form S-1 of the Registrant filed on December 21, 1995)
 10.3    1995 Employee Stock Purchase Plan, as amended
 10.4    1995 Director Stock Option Plan, as amended (Incorporated by reference
          to the Registrant's Quarterly Report on Form 10-Q filed on August 13,
          1997)
 10.5    Amended and Restated Registration Rights Agreement dated as of August
          12, 1991 by and among the Registrant and the parties named therein
          (Incorporated by reference to the Registration Statement on Form S-1
          of the Registrant filed on December 21, 1995)
 10.6    Lease dated as of January 1, 1995 by and between the Registrant and
          CambridgePark One Limited Partnership (Incorporated by reference to
          the Registration Statement on Form S-1 of the Registrant filed on
          December 21, 1995)
 10.7    First Amendment to Lease dated as of December 2, 1996 between the
          Registrant and CambridgePark One Limited Partnership (Incorporated by
          reference to the Registrant's Annual Report on Form 10-K filed on
          March 31, 1997)
 10.8    Second Amendment to Lease dated as of January 24, 1997 between the
          Registrant and CambridgePark One Limited Partnership (Incorporated by
          reference to the Registrant's Annual Report on
          Form 10-K filed on March 31, 1997)
 10.9    Third Amendment to Lease dated as of January 24, 1997 between the
          Registrant and CambridgePark One Limited Partnership (Incorporated by
          reference to the Registrant's Annual Report on Form 10-K filed on
          March 31, 1997)
 10.10   Amendment to the Business Loan Agreement dated June 20, 1991 between
          Gensym Corporation and State Street Bank and Trust Company, as
          amended to date (Incorporated by reference to the Registrant's
          Quarterly Report on Form 10-Q filed on August 13, 1997)
 10.11   Distribution Agreement, dated as of January 1, 1995, by and among the
          Registrant, Itochu Corporation and Itochu Techno-Science Corporation
          (Incorporated by reference to the Registration Statement on Form S-1
          of the Registrant filed on December 21, 1995)
 10.12   Severance arrangement with Raymond Wood dated December 6, 1996, as
          modified on December 31, 1996 and January 22, 1997 (Incorporated by
          reference to the Registrant's Annual Report on Form 10-K filed on
          March 31, 1997)
 10.13   1997 Stock Incentive Plan (Incorporated by reference to the
          Registrant's Quarterly Report on
          Form 10-Q filed on August 13, 1997)
 10.14   Sublease Agreement dated August 26, 1997 between Gensym Corporation
          and Spaulding & Slye Services Limited Partnership (Incorporated by
          reference to the Registrant's Quarterly Report on Form 10-Q filed on
          November 12, 1997)
</TABLE>
 
 
                                       51
<PAGE>
 
                           EXHIBIT INDEX--(CONTINUED)
 
<TABLE>
<CAPTION>
 EXHIBIT NO.                            DESCRIPTION
 -----------                            -----------
 <C>         <S>
 10.15       Secured Promissory Note dated October 1, 1997 from Stephen R.
              Quehl to Gensym Corporation (Incorporated by reference to the
              Registrant's Quarterly Report on Form 10-Q filed on November 12,
              1997)
 10.16       Pledge Agreement dated October 1, 1997 between Gensym Corporation
              and Stephen R. Quehl (Incorporated by reference to the
              Registrant's Quarterly Report on Form 10-Q filed on November 12,
              1997)
 10.17       Rights Agreement, dated as of April 8, 1997, between Gensym
              Corporation and State Street Bank & Trust Company, as Rights
              Agent (Incorporated by reference to the Registrant's Current
              Report on Form 8-K filed on April 17, 1997)
 21          Subsidiaries of the Registrant
 23          Consent of Arthur Andersen LLP
 27          Financial Data Schedule
</TABLE>
 
NOTES
 
Exhibit 10.11--Confidential treatment has been granted with respect to certain
portions of this agreement.
 
Exhibit 10.12--Management contract or compensatory plan or arrangement required
to be filed as an exhibit to this Annual Report on Form 10-K
 
                                       52