<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, 1998

                                      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 of                        (I.R.S. Employer
incorporation or organization)                         Identification No.)

   125 CAMBRIDGEPARK 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.   
                             -----

     As of March 25, 1999 there were 6,055,945 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 $16,653,849 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 25, 1999.

                                       1
<PAGE>
 
                      DOCUMENTS INCORPORATED BY REFERENCE


                                        

                                                          Part of Form 10-K
   Document                                             into which incorporated
   --------                                             -----------------------

   Portion of the Registrant's Proxy Statement
   for the 1999 Annual Meeting of Stockholders        Items 10, 11, 12 and 13 of
   to be held on Friday, May 21, 1999 at              Part III
   10:00 A.M. at the offices of Hale & Dorr LLP,
   60 State Street, Boston, MA 02109

                                       2
<PAGE>
 
                              GENSYM CORPORATION
                                FORM 10-K INDEX
                                        
<TABLE>
<CAPTION>
                                                                                      Page No.
                                                                                      --------
   <S>         <C>                                                                    <C>
   PART I
 
   Item 1.     Business                                                                4-14
   Item 2.     Properties                                                                14
   Item 3.     Legal Proceedings                                                         14
   Item 4.     Submission of Matters to a Vote of Security Holders                       14
 
 
   PART II
 
   Item 5.     Market for Registrant's Common Equity and Related Stockholder Matters     15
   Item 6.     Selected Financial Data                                                15-16
   Item 7.     Management's Discussion and Analysis of Financial Condition and
               Results of Operations                                                  16-28
   Item 7A.    Qualitative and Quantitative Disclosures about Market Risk                29
   Item 8.     Financial Statements and Supplementary Data                            30-42
   Item 9.     Changes in and Disagreements with Accountants on Accounting
               and Financial Disclosure                                                  43
 
 
   PART III
 
   Item 10.    Directors and Executive Officers of the Registrant                        43
   Item 11.    Executive Compensation                                                    43
   Item 12.    Security Ownership of Certain Beneficial Owners and Management            43
   Item 13.    Certain Relationships and Related Transactions                            43
 
   PART IV

   Item 14.    Exhibits, Financial Statements and Reports on Form 8-K                    44
               Signatures                                                                45
</TABLE> 

                                       3
<PAGE>
 
   PART I.

   ITEM 1.  BUSINESS

      Gensym Corporation ("Gensym" or the "Company") is a leading supplier of
   software products and services for intelligent operations management.  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 actions in real time.  These products can also be 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 mainstream markets.  In order
   to better meet the buying requirements of companies in its primary target
   markets, the Company has reorganized into four business units: Manufacturing,
   Communications, Advanced Systems, and EMA (Europe/Middle East/Africa).  These
   business units generally have their own specialized sales, business
   development, consulting, and product development resources to provide the
   level of application and industry specific knowledge needed to achieve
   sustained growth and profitability in their respective markets.
   Reorganization of the Company into business units with greater application
   focus has entailed a retraining of the sales force and a major change in
   account structure.

   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 at the level of application products that 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 power,
      interoperability, and ease of use of its products by developing additional
      application functionality, development tools, utility components, object
      libraries, and interfaces that support important object- and data-exchange
      standards.

        Develop Business Units for Increased Sales and Application Effectiveness
      in Target Markets.  To better align its sales resources with today's
      market requirements, Gensym has changed, beginning in 1999, from a unified
      worldwide sales organization to focused sales teams operating within four
      business units:  Manufacturing, Communications, Advanced Systems, and EMA
      (Europe/Middle East/Africa).  The Company believes that this strengthened
      business unit structure better supports the level of application knowledge
      needed to sell effectively and achieve high rates of application success
      in its target markets.

        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.   Gensym has 20
      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.

        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.

        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
      relationships with its strategic partners to help accomplish this goal.

                                       4
<PAGE>
 
   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 Compaq/Digital, Hewlett-Packard, IBM, Sun
      Microsystems and others.  G2 currently runs under Windows NT, as well as
      the UNIX and VMS operating systems.

      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 

                                       5
<PAGE>
 
      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.

        Released in October 1998, Telewindows2 Toolkit is an entirely new
      component-based version of Telewindows 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 legacy Telewindows product.  Telewindows2 Toolkit permits a G2
      client to be developed and deployed within industry standard programming
      environments, such as Microsoft Visual Basic, Microsoft Explorer, and
      Netscape Navigator.  G2 programming components such as workspaces and
      editors can be presented in a standards compliant manner.  Telewindows2
      Toolkit also supports the integration of both JavaBean and ActiveX
      components into the client part of a G2 application.

        In addition to Telewindows, G2 WebLink enables users to interact with G2
      applications remotely from browsers like Netscape and Microsoft Explorer.
      Through support of hypertext transfer protocol (HTTP), this product "Web-
      enables" G2, that is, provides standard user access over Internet or
      Intranet connections.

   CONNECTIVITY PRODUCTS

         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.  The
      Company is currently developing an interface module for integration of G2
      with object-oriented databases.  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.

      During 1998, Gensym released three new products that support industry
      object-exchange standards.  These products include:

   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 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 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-RELATED PRODUCTS

      The Company also offers a number of products that are built on G2 or
   commonly operate in conjunction with G2.  These G2-related products include
   the following.

   OPERATIONS EXPERT

      Operations Expert (OPEX) is a family of products designed to add
      intelligence and value to traditional network management systems such as
      HP OpenView and IBM NetView and to provide intelligent operations support
      capable of addressing today's complex communications operations problems.
      With OPEX, users have an enhanced ability to meet service-level
      agreements, to manage growth cost-effectively, to minimize the risks of
      implementing new services and technologies, and to gain competitive
      advantage.  Key functional uses include early detection of network
      problems, alarm/message/event filtering, alarm correlation across
      disparate platforms, root cause analysis, anticipating effects of network
      failures, and recommending and/or automating appropriate corrective
      actions.

                                       6
<PAGE>
 
      The OPEX product family includes:
      . OPAC--a general-purpose graphical language designed for easy graphical
        representation of operational procedures
      . Causal Directed Graph (CDG)--for building fault models that
        automatically pinpoint root causes of failures
      . IP Reachability Analyzer (IPRA)--for isolating the sources of network
        outages through model-based reasoning and proactive network probes

   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 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.

   NEURON-LINE STUDIO

      Released in December 1998, NeurOn-Line Studio is a Windows desktop tool
      for off-line analysis, modeling, and design optimization of processes,
      based on data from a data historian or spreadsheet data arrays.  To make
      the tool easy for process engineers to use, many technical decisions such
      as selection of relevant inputs, time delays, and network architecture are
      automated.  Once a model has been built for a process, NeurOn-Line Studio
      allows users to discover more profitable ways to run it through simulation
      and optimization.  NeurOn-Line Studio models can be deployed either in a
      G2 environment or as Microsoft ActiveX objects in embedded Windows
      applications.

   RETHINK

      ReThink supports the design, simulation and operational management of
      processes. Using ReThink, process teams can work together to explore
      alternative business or manufacturing 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 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, enabling process models to be put on-line to create process
      monitoring, executive information systems, or workflow control
      applications.

   FERMENTATION EXPERT

      Fermentation Expert, introduced in 1998, supports the intelligent control
      and management of difficult-to-control fermentation processes.  Its out-
      of-the-box application-specific capabilities make it easier for
      pharmaceutical and biochemical companies to develop fermentation control
      applications than if they were to begin with Gensym's G2 and GDA products,
      as they historically have.

   PRODUCTS UNDER DEVELOPMENT

      The Company is presently developing new G2-related products.  The products
   and product families discussed below are in various stages of development and
   pre-release and are expected to be released within the next twelve months.

   G2 AGENTS

      The G2 Agents family of products extends the power of Gensym technology by
      allowing its distribution across a network, thus supporting massive scale-
      up in the size and complexity of intelligent operations management
      applications.  G2 Agents are intelligent agent programs that can be
      generated to operate and co-operate on behalf of a G2 host application.
      G2 Agents can greatly offload and distribute intelligent processing from a
      G2 host application and the network on which it runs by bringing that
      processing closer to the sources of data and events.  This is valuable,
      for example, in applications that maintain the availability of large
      communications networks.  Such networks are difficult to manage since they
      have vast numbers of low-level events that must be continually monitored
      and analyzed.  G2 Agents can be deployed throughout a network to locally
      monitor and filter events, and then, either directly or at the G2 host
      level, actions can be taken to resolve problems quickly.  Other
      application areas that can benefit from the distributed intelligent
      processing enabled by G2 Agents include: supply chain 

                                       7
<PAGE>
 
      management, advanced process control, and real time mining of data within
      an organization's on-line transaction processing systems (OLTPs).

      The G2 Agents family of products will provide a comprehensive environment
      for creating, testing, and deploying intelligent agent applications.  It
      will offer a visual language for graphically building and deploying
      agents; a simulator for testing agent applications before putting them on
      line; a distributed rule and computation processor for handling a high
      volume of data and events; a deployment engine for dynamic downloading and
      updating of agents on network nodes; and a control center for monitoring
      agent processes, correlating information from multiple agents, and taking
      actions that are beyond the scope of individual agents.  Major products in
      the G2 Agents family will include G2 Agent Development Environment (ADE),
      for visually building and testing agent applications, and G2 Agent
      Deployment Center (ADC), for automatically distributing and managing
      agents in real time.  G2 ADE has already been used for several
      applications in the manufacturing and financial industries.  G2 ADC is
      currently scheduled to go into beta testing at multiple sites in 1999.

   INTELLIGENT TRANSACTION MINING TOOLKIT (ITM)

      Gensym's Intelligent Transaction Mining Toolkit (ITM) supports the rapid
      development of applications that use G2 Agents to "eavesdrop" on
      transaction streams passed among an organization's on-line transaction
      processing systems (OLTPs).  Agents "sniff" transactions and identify
      those that match a profile for further real-time processing.  Such further
      processing may be graphically specified and may entail interpretation,
      correlation with other data, and real-time response (e.g., displaying a
      message, sending email, generating a Web page, initiating another
      transaction, etc.).  ITM applications are massively scalable, flexible,
      and do not interfere with underlying OLTPs.  ITM will be valuable to
      organizations that have been prevented from tapping the wealth of data in
      their transactions because of high costs and risks to their OLTP systems.
      Markets include financial services, government and military, and e-
      commerce.  The first ITM-based product has been developed for an OEM and
      is undergoing testing at a customer site.  Gensym plans to immediately
      begin seeking relationships with additional  OEMs and large-scale
      integrators who serve the financial services, customer relationship
      management, and e-commerce markets.

   LAB EXPERT

      Lab Expert is a G2-based product that supports reduction of the new drug
      development cycle time in pharmaceutical companies by improving the
      productivity of chromatography methods development and execution.  Lab
      Expert is currently installed at a customer site, and release is
      anticipated in late 1999.

                                       8
<PAGE>
 
   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:

<TABLE>
<CAPTION>
              AEROSPACE                                             FOOD AND BEVERAGE
              ---------                                             -----------------
              <S>                                                   <C>   
              Boeing                                                Cargill
              Hughes Aircraft                                       Nabisco
              Lockheed Martin                    
              NASA                                                  GOVERNMENT
              Storm Control Systems                                 ----------
                                                                    Defence Education and Research Agency (UK)
              AUTOMOTIVE                                            US Army AI Center
              ----------                         
              Ford                               
              Nissan                                                MINING
              Toyota (Japan)                                        ------
                                                                    Noranda
              CEMENT                                                Met-Mex Penoles (Mexico)
              ------                                                Anglo American (S. Africa)
              Lafarge (France)                   
                                                 
                                                                    PHARMACEUTICAL
              CHEMICAL, OIL AND GAS                                 --------------
              ---------------------                                 Eli Lilly
              ABB Simcon                                            Pfizer
              Amoco Oil                                             Glaxo                                 
              AspenTech                                                                                    
              British Petroleum                                     TELECOMMUNICATIONS                     
              Citgo Petroleum                                       ------------------                     
              Exxon                                                 AT&T                                   
              PDVSA (Venezuela)                                     Ericsson Hewlett-Packard (Sweden)      
              Siebe                                                 EUMETSAT (Germany)                     
              ICI Chemicals (UK)                                    GTE                                    
              Phillips Petroleum                                    MCI                                    
              Saudi Aramco                                          Motorola                               
              Shell                                                                                        
              Union Carbide                                         TRANSPORTATION                         
                                                                    --------------                         
              FINANCIAL                                             Aeroport International de Lyon (France)
              ---------                                             Serco Systems (UK)                     
              Andersen Consulting                                   US Dept. of Transportation             
              Fidelity Investments                                                                         
              MBNA                      
              SWIFT                     
                                        
                                        
                                        
                                        
</TABLE>

   The Company has sold more than 11,000 licenses, which include both single-
   user and multiple-user site licenses, for its products to over 750
   industrial, service and governmental organizations in more than 59 countries.
   The Company's products are used internationally in a broad array of
   applications, including the following with industries noted:

   BRITISH PETROLEUM, Et Al - Oil and Gas

      Gensym and Gensym Solution Partner EDS developed 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 acts as an export hub for all the oil and gas produced. G2
      applications are used for an operator advisory system, a production
      forecasting system, and a capacity allocations system.

   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 

                                       9
<PAGE>
 
      applications. CITGO's Corpus Christi refinery was recognized by 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.

   COMPUTER SCIENCES CORPORATION - COMMUNICATIONS

      Computer Sciences Corporation (CSC) uses Gensym's products as the "brains"
      of a new class of Information Security Systems (ISS). Combining the output
      from other security tools, network management tools, and systems
      management tools with the knowledge of security experts, CSC's ISS applies
      the power of Gensym's reasoning engines in real time to identify security
      attacks that cannot be detected by any one tool. Once detected,
      notification of a potential attack is broadcast immediately with a format
      and content appropriate to the different audiences receiving it. The
      system uses multiple communications media for notification, including on-
      screen alarms, paging, and e-mail and, in the absence of a response, can
      automatically escalate the problem.

   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.

   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.

   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.

   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.

   LOGISTICS INTEGRATION AGENCY - GOVERNMENT

      The U.S. Army's Logistics Integration Agency (LIA) is using ReThink,
      Gensym's process modeling and simulation tool, to better understand the
      Army's supply chain.  The supply chain is complex and prone to inefficient
      use, resulting in inventory tracking problems, long lead times, and
      financial management difficulties.  With ReThink, LIA constructed an
      animated model of the entire supply chain, from the retail level to the
      troops in the field.  This model supports "what-if" analysis and can
      measure service times and costs, inventory levels, resource requirements,
      and financial performance.  ReThink has given senior officers their first
      end-to-end view of the supply process, has become an important training
      tool for military logisticians, and is the key element in a newly-
      established laboratory for logistics policy studies.

                                       10
<PAGE>
 
   MANITOBA - GOVERNMENT

      The Provincial Government of Manitoba has been using ReThink to support
      its Better Systems Initiative.  The purpose of the initiative is to use
      information and Internet technologies to improve government services.
      Manitoba has used Gensym's ReThink to design and re-engineer its core
      business and human services processes in pursuit of the initiative's
      visionary goals.

   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.

   THE PANAMA CANAL COMMISSION - Transportation

      The Panama Canal Commission selected Gensym's G2 product to build a
      critical component of its Enhanced Vessel Traffic Management System
      (EVTMS).  This system is designed to develop and monitor transit schedules
      for all ships traveling through the canal.  The schedules involve the
      complex coordination of resources such as tug boats and locomotives.  The
      location and status of all ships and resources are monitored, and
      schedules are regenerated as necessary.  EVTMS will provide the canal with
      Y2K compliant, 24x7 automated support for canal operations when control of
      the canal reverts to Panama.

   SALES AND MARKETING

      In order to reach the broadest possible market, the Company's business
   units utilize their direct sales resources and over 100 selected marketing
   partners.

      The Company markets its products in North America, Europe, Africa, and
   parts of Asia through its business units, which together employ 31
   salespersons and 23 solutions engineers as of December 31, 1998.  As of
   December 31, 1998, 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.  In 1996,
   1997, and 1998, the Company received 42%, 46%, and 47% of its total revenues,
   respectively, from international operations.  See Note 8 of Notes to
   Consolidated Financial Statements for financial information by geographic
   area.

      The Company's four strategic business units sell to major accounts and
   provide face-to-face contact with customers, both directly and through
   partners.  Solutions engineers perform demonstrations at customer sites and
   assist customers in evaluating their technical requirements and in
   implementing G2 application prototypes.  Regular seminars and workshops are
   hosted at the Company's larger offices to demonstrate the Company's products.
   The Company offers basic and advanced training courses that teach prospective
   and new customers how to build application solutions using the Company's
   products.

      The Company also distributes its products through 167 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, Siebe Foxboro, Siemens,
   Science Systems, and L3 Communications. Product revenues from systems
   integrators and value-added resellers represented over 28%, 35%, and 25% of
   the Company's product revenues for 1996, 1997, and 1998, 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%, 8%, and 3% of the Company's product revenues
   in 1996, 1997, and 1998, respectively.

      Gensym also licenses technology to OEMs, who embed it within their product
   offerings.  Gensym has established relationships with several OEMs including
   Ericsson Hewlett-Packard Telecommunications ("EHPT"), an independent software
   company established by Ericsson and Hewlett Packard, and Motorola.  EHPT has
   chosen Gensym's G2 software as the foundation for its Fault Management eXpert
   (FMX) product that intelligently handles network faults.  Motorola uses
   Gensym's G2 technology for the intelligence within their Network Health
   Analyzer (NHA), a new product within their cellular infrastructure family.

      The Company's marketing personnel engage 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.

                                       11
<PAGE>
 
   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, 1998, the
   Company's business units together employed a staff of 44 full-time
   consultants, which they supplement, 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, Massachusetts, at its worldwide sales offices, and at customer
   locations.  In 1998, more than 1,000 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.

      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 and consulting 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, 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, 1998, Gensym had 52 employees engaged in research and
   development, including software and hardware engineering, test and quality
   assurance and technical documentation.  In 1996, 1997, and 1998 Gensym's
   research and development expenditures totaled $6.0 million, $7.0 million, and
   $6.0 million, respectively, representing 16.1%, 19.6%, and 17.2% 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 its 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., Micromuse,
   Systems Management Arts (SMARTS), and Pavilion sell "point solutions" that
   compete with the Company's products with respect to specific applications or
   uses.  However, an 

                                       12
<PAGE>
 
   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 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 - Competition."

   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(R), G2(R), NeurOn-Line(R), ReThink(R), and Operations Expert(R) are
   registered trademarks of the Company.  The Gensym logo, GDA, ReThink, G2
   WebLink, and OPEX are trademarks of the Company.  The Company has filed
   applications to register Gensym, G2, NeurOn-Line, 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.

                                       13
<PAGE>
 
   EMPLOYEES

      As of December 31, 1998, the Company had 256 full-time employees,
   including 97 in sales and marketing, 52 in product development, 47 in
   consulting services, 27 in customer support, production and licensing, and
   educational services, and 33 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.

   ITEM 2.  PROPERTIES

      The Company's headquarters and principal operations are located in a
   leased facility with 52,322 square feet in Cambridge, Massachusetts.  The
   Company's lease expires on December 31, 2000, with an option to renew for an
   additional term of five years.  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, the Netherlands, Singapore, Sweden, Tunisia and the United
   Kingdom.  The Company has its European headquarters 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 1998 was $1.8 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 securityholders during
   the fourth quarter of 1998.

   EXECUTIVE OFFICERS OF THE COMPANY

      The executive officers of the Company and their respective ages as of
   March 10, 1999 are as follows:

<TABLE>
<CAPTION>
          Name               Age                      Position
                           
   <S>                       <C>   <C>
   Lowell B. Hawkinson       56    Chairman of the Board of Directors, Chief Executive Officer, Treasurer and Secretary
   Robert L. Moore           56    President and Director
   William H. Wood           60    Senior Vice President, Communications Business Unit
   James T. Pepe             54    Vice President, Product Development
   Mark H. Whitworth         47    Vice President, Advanced Systems Business Unit
   Carl Davies               37    Vice President and Managing Director, EMA
</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.

   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.

   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 

                                       14
<PAGE>
 
   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.

   Mr. Davies joined the Company in 1993 as an Area Sales Manager for the United
   Kingdom region.  He was promoted in 1996 to Director of Sales for EMA
   (Europe/Middle East/Africa) and in 1998 to Vice President of Operations for
   EMA.  Previously, Mr. Davies worked with British Petroleum as a software and
   systems engineer, two years of which were spent working with BP Ventures.
   Mr. Davies holds a B.S. degree in Mechanical Engineering and a Masters degree
   in Systems Engineering from the University of Wales Institute of Science and
   Technology, Cardiff, Wales.


   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 by quarter, for the years 1997 and 1998.

<TABLE>
<CAPTION>
               1997                 High              Low
          -------------------    ------------     ----------
          <S>                    <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
                                
               1998                 High              Low
          -------------------    ------------     ----------
          First quarter              8   7/8        4  9/16
          Second quarter             8   3/4        4  5/16
          Third quarter              4 11/16        2 15/16
          Fourth quarter             4 11/16        1   3/4
 
</TABLE>

      The Company has never declared or paid cash dividends on its capital
   stock.  The Company 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 25,
   1999 was 108. This number does not include stockholders for whom shares are
   held in a "nominee" or "street" name.

   (B) STOCK REPURCHASE PROGRAM

      In the third quarter of 1998, the Company began a program to repurchase up
   to 650,000 shares of its Common Stock on the open market.  As of December 31,
   1998, 345,200 shares had been repurchased at a cost of $1,278,000.

   ITEM 6.  SELECTED FINANCIAL DATA

      The selected consolidated balance sheet data presented below as of
   Decembers 31, 1998 and 1997 and the selected consolidated statement of
   operations data for each of the three years in the period ended December 31,
   1998 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, 1996, 1995, and 1994, and the selected consolidated
   statement of operations data for the years ended December 31, 1995 and 1994,
   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.

                                       15
<PAGE>
 
<TABLE>
<CAPTION>
                                                                              YEAR ENDED DECEMBER 31,
                                                      1998             1997             1996            1995            1994
                                             ----------------------------------------------------------------------------------
<S>                                               <C>              <C>              <C>             <C>             <C>    
CONSOLIDATED STATEMENT OF 
   OPERATIONS DATA:
Revenues:
     Product                                      $16,910,670      $18,433,520      $21,358,295     $16,438,400     $11,426,593
     Service                                       18,067,035       17,075,603       15,877,240      11,702,577       8,164,778
                                             ----------------------------------------------------------------------------------
        Total revenues                             34,977,705       35,509,123       37,235,535      28,140,977      19,591,371
 
Cost of Revenues                                    8,697,594        9,352,348        7,385,215       5,314,654       2,823,037
                                             ----------------------------------------------------------------------------------
Gross profit                                       26,280,111       26,156,775       29,850,320      22,826,323      16,768,334
                                             ----------------------------------------------------------------------------------
Operating expenses:
     Sales and marketing                           18,275,852       18,802,113       17,432,861      14,568,045       9,371,574
     Research and development                       6,022,931        6,977,143        5,983,741       5,267,461       4,590,220
     General and administrative                     4,133,849        4,528,147        3,699,254       2,619,103       2,630,943
     Restructuring charge                                   -        1,557,253                -               -               -
                                             ----------------------------------------------------------------------------------
        Total operating expenses                   28,432,632       31,864,656       27,115,856      22,454,609      16,592,737
                                             ----------------------------------------------------------------------------------
Operating income (loss)                            (2,152,521)      (5,707,881)       2,734,464         371,714         175,597
Other income, net                                     714,509          779,118          517,758         236,030         258,077
                                             ----------------------------------------------------------------------------------
Income (loss) before provision for 
     income taxes                                  (1,438,012)      (4,928,763)       3,252,222         607,744         433,674 
Provision for income taxes                             50,000           40,000        1,204,000         411,000         302,000
                                             ----------------------------------------------------------------------------------
Net income (loss)                                 $(1,488,012)     $(4,968,763)     $ 2,048,222     $   196,744     $   131,674
                                             ==================================================================================
Basic income (loss) per share (1) (2)                  $(0.23)          $(0.79)           $0.35           $0.05           $0.03
                                             ==================================================================================
Diluted income (loss) per share (1) (2)                $(0.23)          $(0.79)           $0.33           $0.04           $0.03
                                             ==================================================================================
Weighted average common shares 
     outstanding (1) (2)                            6,371,190        6,309,815        5,909,511       3,993,600       3,990,531
                                             ==================================================================================
 
Weighted average common shares outstanding
     assuming dilution (1)(2)                       6,371,190        6,309,815        6,286,170       4,762,245       4,758,411
                                             ==================================================================================
 
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term 
     investments                                  $14,533,627      $15,801,349      $19,589,852     $ 5,092,201     $ 6,772,671
Working capital                                    14,650,126       15,148,820       20,469,778       6,176,328       6,585,277
Total assets                                       28,267,762       31,517,107       36,257,621      17,846,495      14,335,231
Total stockholders' equity                        $17,483,311      $19,828,365      $24,068,455     $ 8,610,577     $ 8,360,244
</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

   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
   intelligent operations management.  The Company's core product, G2, and G2-
   based products are sold to customers for a broad array of intelligent
   operations management applications in a wide range of industries, including
   manufacturing, telecommunications, government, aerospace, transportation, and
   financial services.  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 value-added resellers and systems integrators, who provide
   consulting services and integrated solutions to their customers.  The Company
   further licenses technology to OEMs, who embed it within their product
   offerings.

      In order to better meet the buying requirements of companies in its
   primary target markets, the Company has reorganized into four business units:
   Manufacturing, Communications, Advanced Systems, and EMA (Europe/Middle
   East/Africa).  These business units generally have their own specialized
   sales, business development, consulting, and product development resources to
   provide the level of application and industry specific knowledge needed to
   achieve sustained growth, and profitability in their respective markets.
   Reorganization of the Company into business units with greater application
   focus has entailed a retraining of the sales force and a major change in
   account structure.

      The Company continued tight control over operating costs throughout 1998,
   maintaining level headcount and instituting cost controls as necessary.

                                       16
<PAGE>
 
      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".

                                       17
<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,
                                                   1998                    1997                    1996
                                             ---------------        ----------------        ----------------
          <S>                                <C>                    <C>                     <C>  
          Revenues:
            Product                               48.3%                   51.9 %                  57.4 %
            Service                               51.7                    48.1                    42.6
                                             ---------------        ----------------        ----------------
              Total revenues                     100.0                   100.0                   100.0
 
          Cost of revenues                        24.9                    26.3                    19.9
                                             ---------------        ----------------        ----------------
          Gross margin                            75.1                    73.7                    80.1
                                             ---------------        ----------------        ----------------
            Sales and marketing                   52.3                    53.0                    46.8
            Research and development              17.2                    19.6                    16.1
            General and administrative            11.8                    12.8                     9.9
            Restructuring charge                     -                     4.4                       -
                                             ---------------        ----------------        ----------------
              Total operating expenses            81.3                    89.8                    72.8
                                             ---------------        ----------------        ----------------
Operating income (loss)                           (6.2)                  (16.1)                    7.3
 
Other income, net                                  2.0                     2.2                     1.4
                                             ---------------        ----------------        ----------------
Income (loss) before provision for 
          income taxes                            (4.2)                  (13.9)                    8.7
 
Provision for income taxes                         0.1                     0.1                     3.2
                                             ---------------        ----------------        ----------------
Net income (loss)                                 (4.3)  %               (14.0)  %                5.5 %
                                             ===============        ================        ================
</TABLE>

                                       18
<PAGE>
 
   YEARS ENDED DECEMBER 31, 1998 AND 1997

   REVENUES

      The Company's operating revenues are derived from two sources: product
   licenses and services. Product revenues include revenues from sales of
   licenses for use of the Company's software products.  Service revenues
   consist of fees for maintenance contracts, consulting services, and training
   courses related to the Company's products.

      Total revenues were $35.0 million for the year ended December 31, 1998 as
   compared to $35.5 million for 1997, a decrease of $0.5 million or 1.5%.  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 47% and 46% of total revenue in 1998 and 1997,
   respectively.

      Product.  Product revenues decreased to $16.9 million for the year ended
   December 31, 1998 from $18.4 million in 1997, a decrease of 8.3%.  The
   decrease in product revenues reflects, in large part, decreased demand for
   the Company's products in the Asia-Pacific region and in the petrochemical
   industry where low oil prices have resulted in tighter budgets and delayed
   purchase decisions.  The Company has historically derived a significant
   percentage of its revenue from the petrochemical industry.  Also contributing
   to decreased revenue is the diversion of resources by some customers and
   prospects to address Y2K issues, resources that might otherwise have been
   used to develop and deploy G2-based solutions.  The Company expects product
   revenues to increase, due to the Company's reorganization into more focused
   and specialized business units that can provide the required level of
   application and industry specific knowledge and products in the Company's
   most promising markets and due to anticipated resolution of the Year 2000
   issue.

      Service.  Service revenues increased to $18.1 million for the year ended
   December 31, 1998 from $17.1 million in the same period in 1997, an increase
   of 5.8%.  The increase in service revenues was primarily due to an increase
   in application consulting revenues and, to a lesser extent, increased
   maintenance fees derived from an increased customer base, partially offset by
   a decrease in educational services.  Maintenance revenues increased to $9.2
   million for the year ended December 31, 1998 from $9.0 million in the same
   period in 1997, an increase of 2.2%.  Consulting fees increased to $7.6
   million for the year ended December 31, 1998 from $6.5 million in the same
   period in 1997, an increase of 16.9%.  Fees for educational services
   decreased to $1.3 million for the year ended December 31, 1998 from $1.6
   million in the same period in 1997, a decrease of 18.8%.

   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 decreased to $8.7
   million in 1998 from $9.4 million in 1997, a decrease of 7.0%.  This decrease
   was primarily due to a decrease in consulting labor costs.  Gross margin on
   revenues increased to 75.1% for the year ended December 31, 1998 from 73.7%
   in the same period in 1997.  The increase in gross profit resulted primarily
   from improved utilization of consulting personnel coupled with higher
   consulting revenues and lower product distribution costs.

   OPERATING EXPENSES

      Total operating expenses decreased to $28.4 million for the year ended
   December 31, 1998 from $31.9 million in the same period in 1997, a decrease
   of 10.8%, due principally to cost reduction measures that were implemented in
   1997.  Such reductions included a 15% reduction in staff as well as reduced
   facilities and related costs.

      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, 1998, these expenses decreased 2.8% to $18.3 million (52.3% of
   total revenues) from $18.8 million (53.0% of total revenues) for the
   comparable period in 1997.  The decrease in absolute dollars was primarily a
   result of a decrease in sales and marketing personnel and the closing and
   consolidation of several field sales offices.  The Company plans to maintain
   approximately the current level of direct sales personnel and marketing
   expenses in the coming year. It is expected that sales and marketing expenses
   as a percentage of total revenues will decrease from 1998 levels due to
   anticipated higher revenues.

      Research and Development.  Research and development expenses consist
   primarily of costs of personnel, equipment, and facilities. Research and
   development expenses decreased 13.7% to $6.0 million (17.2% of total
   revenues) for the year ended December 31, 1998 from $7.0 million (19.6% of
   total revenues) for the comparable period in 1997.  The decrease in absolute
   dollars was primarily due to a reduction in personnel, the consolidation of
   headquarter facilities, and other actions taken in connection with the
   Company's restructuring implemented in the previous year.  The Company
   achieved its major product release goals in 1998.  The Company expects that
   research and development expenses will decrease slightly as a percentage of
   total revenues due to anticipated higher 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 decreased 8.7% to $4.1 million (11.8% of total
   revenues) for the year ended December 31, 1998 from $4.5 million (12.8% of
   total revenues) for the comparable period in 1997. The decrease in absolute
   dollars was primarily due to a reduction in personnel, the consolidation 

                                       19
<PAGE>
 
   of headquarters facilities, and other actions taken in connections with the
   Company's restructuring plan as primarily implemented in 1997.

      Restructuring Charge.  In 1998, no provision for a restructuring charge
   was made.  As of June 30, 1998, the Company had taken actions in all intended
   areas consistent with its restructuring plan of June 1997 and had
   substantially completed that plan.

   OTHER INCOME

      Other income consists primarily of interest income augmented by net
   foreign exchange transaction gains. For the year ended December 31, 1998,
   other income decreased to $715,000 from $779,000 for the comparable period in
   1997. The decrease was primarily due to the Company's recording of a one-time
   benefit in 1997 relating to the recovery of its interest in a joint venture.
   The reduction was partially offset by an increase in investment income from
   $591,000 in 1997 to $678,000 in 1998.  The Company has historically
   experienced nominal net foreign exchange transaction gains or losses.

   INCOME TAXES

      The Company recorded a provision for income taxes of $50,000 and $40,000,
   for the years ended December 31, 1998 and 1997, respectively.  The provision
   in both years represents income taxes on income generated in foreign
   jurisdictions. The Company generated a significant tax loss carryforward
   during the year ended December 31, 1998.  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 a portion of its deferred tax asset
   to the extent that it cannot conclusively demonstrate that it is "more likely
   than not" that these assets 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.


   YEARS ENDED DECEMBER 31, 1997 AND 1996

   REVENUES

      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 revenues 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 attributed primarily 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.

      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 in the same period in 1996, an increase of 6.2%.  Fees for
   educational services increased $200,000 for the year ended December 31, 1997,
   as compared to the same period in 1996.

   COST OF REVENUES

      Cost of revenues increased to $9.4 million for the year ended December 31,
   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 in 1997 as a
   percentage of total revenues, and to a lesser extent, an increase in
   consulting personnel, including outside contractors, and in technical support
   personnel.

   OPERATING EXPENSES

      Sales and Marketing.  For the year ended December 31, 1997, sales and
   marketing 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.

                                       20
<PAGE>
 
      Research and Development.  Research and development 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.

     General and Administrative.  General and administrative 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.

      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.  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.  In 1996, no provision for a
   restructuring charge was made.

   OTHER INCOME

      Other income for the year ended December 31, 1997 consisted primarily of
   interest income, partially offset by net foreign exchange transaction losses
   and by the Company'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 1996.  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 a portion of its deferred tax asset to the extent that it
   cannot conclusively demonstrate that it is  "more likely than not" that these
   assets 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.

   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.

                                       21
<PAGE>
 
<TABLE>
<CAPTION>
                                                                           QUARTER ENDED
                                     DEC. 31,   SEPT. 30,     JUNE 30,  MAR. 31,    DEC. 31,    SEPT. 30,     JUNE 30,     MAR. 31,
                                       1998        1998         1998      1998        1997         1997         1997         1997
                                   ------------------------------------------------------------------------------------------------
                                                                          (IN THOUSANDS)
<S>                                   <C>       <C>           <C>        <C>        <C>          <C>           <C>          <C>   
Revenues:                                                              
      Product                         $ 3,509      $4,258       $4,520    $4,624      $5,275      $ 3,889      $ 3,337      $ 5,932
      Service                           4,614       4,489        4,504     4,460       4,236        4,202        4,538        4,099
                                      -------      ------       ------    ------      ------      -------      -------      -------
         Total revenues                 8,123       8,747        9,024     9,084       9,511        8,091        7,875       10,031
                                                                       
Cost of revenues                        2,130       2,193        2,127     2,248       2,223        2,388        2,409        2,331
                                   ------------------------------------------------------------------------------------------------
Gross margin                            5,993       6,554        6,897     6,836       7,288        5,703        5,466        7,700
                                   ------------------------------------------------------------------------------------------------
Operating expenses:                                                    
      Sales and marketing               4,764       4,563        4,686     4,263       4,583        4,471        5,038        4,711
                                                                       
      Research and development          1,517       1,516        1,532     1,459       1,554        1,654        1,902        1,866
                                                                       
      General and administrative        1,123         934        1,002     1,074       1,084        1,150        1,293        1,001
                                                                       
      Restructuring charge (credit)         -           -            -         -           -         (485)       2,042            -
                                   ------------------------------------------------------------------------------------------------
          Total operating expenses      7,404       7,013        7,220     6,796       7,221        6,790       10,275        7,578
                                   ------------------------------------------------------------------------------------------------
Operating income (loss)                (1,411)       (459)        (323)       40          67       (1,087)      (4,809)         122
                                                                       
Other income, net                         203         179          171       162         137          507          150          (16)

                                   ------------------------------------------------------------------------------------------------
Income (loss) before provision for                                     
      income taxes                     (1,208)       (280)        (152)      202         204         (580)      (4,659)         106
Provision for income taxes                  -           -            -        50           -            -            -           40
                                   ------------------------------------------------------------------------------------------------
Net income (loss)                     $(1,208)     $ (280)      $ (152)   $  152      $  204      $  (580)     $(4,659)     $    66
                                   ================================================================================================
</TABLE>

                                       22
<PAGE>
 
<TABLE>
<CAPTION>
                                                                               QUARTER ENDED
                                        DEC. 31,  Sept. 30, JUNE 30,    MAR. 31     DEC. 31      Sept. 30,  JUNE 30,   MAR. 31,
                                         1998       1998     1998         1998        1997         1997       1997       1997
                                       ---------  --------  --------    --------    --------     --------   -------   --------
                                                                      (AS A PERCENTAGE OF TOTAL REVENUES)
<S>                                    <C>        <C>       <C>         <C>         <C>          <C>        <C>       <C>
Revenues:
  Product                               43.2%     48.7%      50.1%        50.9%       55.5%       48.1%         42.4%      59.1%
  Service                               56.8      51.3       49.9         49.1        44.5        51.9          57.6       40.9
                                       --------  --------   -------     --------     -------     -------      --------    -------
    Total revenues                     100.0     100.0      100.0        100.0       100.0       100.0         100.0      100.0

Cost of revenues                        26.2      25.1       23.6         24.7        23.4        29.5          30.6       23.3

Gross margin                            73.8      74.9       76.4         75.3        76.6        70.5          69.4       76.7
                                       --------  --------   -------     --------     -------     -------      --------    -------
Operating expenses:
  Sales and marketing                   58.7      52.1       51.9         47.0        48.2        55.3          64.0       46.9
  Research and development              18.7      17.3       17.0         16.1        16.3        20.4          24.2       18.6
  General and administrative            13.8      10.7       11.1         11.8        11.4        14.2          16.4       10.0
  Restructuring charge (credit)            -         -          -            -           -        (6.0)         25.9          -
                                       --------  --------   -------     --------     -------     -------      --------    -------
    Total operating expenses            91.2      80.1       80.0         74.9        75.9        83.9         130.5       75.5
                                       --------  --------   -------     --------     -------     -------      --------    -------
Operating income (loss)                (17.4)     (5.2)      (3.6)         0.4         0.7       (13.4)        (61.1)       1.2

Other income, net                        2.5       2.0        1.9          1.8         1.4         6.2           1.9       (0.1)
                                       --------  --------   -------     --------     -------     -------      --------    -------
Income (loss) before provision for
         income taxes                  (14.9)     (3.2)      (1.7)         2.2         2.1        (7.2)        (59.2)       1.1
Provision for income taxes                 -         -          -          0.6           -           -             -        0.4
                                       --------  --------   -------     --------     -------     -------      --------    -------
Net income (loss)                      (14.9)%    (3.2)%     (1.6)%        1.7%        2.1%       (7.2)%       (59.2)%      0.7%
                                       ========  ========   =======     ========     =======     =======      ========    =======
</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.  The Company's lease commitments
   consist of operating leases primarily for the Company's facilities and
   computer equipment.  The Company used $654,000 and $2.9 million in cash for
   operations for the years ended December 31, 1998 and 1997, respectively, and
   generated $3.9 million in cash from operations in 1996.  Cash used for
   operations in 1998 and 1997 was primarily utilized to fund the Company's net
   loss, partially offset by changes in working capital.

   At December 31, 1998, the Company had cash, cash equivalents, and short-term
   investments of $14.5 million. The Company regularly invests excess funds in
   highly-rated money market funds, government securities, and commercial paper.
   During 1998, the Company used $1.3 million of its cash to repurchase its
   shares on the open market.  In addition, the Company received $488,000 in
   1998 from the exercise of stock options and the sale of shares through the
   employee stock purchase plan.  The Company anticipates that it will continue
   to repurchase its shares on the open market.

      At December 31, 1998, 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 April 30, 2000 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 not satisfying the profitability
   and net worth covenant as of December 31, 1998. There were no borrowings
   under the bank line of credit for the year ended December 31, 1998.

      Investing activities provided cash of $4.2 million and $1.5 million in
   1998 and 1997, respectively, and utilized cash of $7.2 million in 1996. In
   1998, the sale of short-term and long-term investments provided $ 5.0 million
   in cash which was partially offset by purchases of $843,000 in property and
   equipment.  The Company expects that its requirements for computers, office
   facilities, office fixtures, and office equipment in 1999 will be at or below
   its requirements for fiscal 1998 and that such equipment and facilities will
   be available when needed.

      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, 1999.

                                       23
<PAGE>
 
   STOCK REPURCHASE PROGRAM

      In the third quarter of 1998, the Company began a program to repurchase up
   to 650,000 shares of its Common Stock on the open market.  As of December 31,
   1998, 345,200 shares had been repurchased at a cost of $1,278,000.

   YEAR 2000 DISCLOSURE

      Historically, certain computer programs have been written using two
   digits, rather than four digits, to define the applicable year.  This could
   lead, for example, to a computer's interpreting "00" as the year 1900 rather
   than the Year 2000.  This phenomenon could result in major computer system
   failures or miscalculations and is generally referred to as the "Year 2000"
   problem or issue.

      The Company has developed a phased Year 2000 readiness plan for the
   current versions of its products.  The plan includes development of corporate
   awareness, assessment, implementation (including remediation, upgrading and
   replacement of certain product versions), validation testing, and contingency
   planning.  The Company continues to respond to customer concerns about prior
   versions of its products on a case-by-case basis.

      The Company has defined "Year 2000 compliant" as the ability to (i)
   correctly handle date information needed for the December 31, 1999 to January
   1, 2000 date change; (ii) function according to the product documentation
   provided for this date change, without changes in operation resulting from
   the advent of a new century, assuming correct configuration; (iii) where
   appropriate, respond to two-digit date input in a way that resolves the
   ambiguity as to century in a disclosed, defined, and predetermined manner;
   (iv) if the date elements in interfaces and data storage specify the century,
   store and provide output of date information in ways that are unambiguous as
   to century; and (v) recognize Year 2000 as a leap year.  The Company has not
   tested its products on all platforms or all versions of operating systems
   that it currently supports and has advised its customers to verify that their
   platforms and operating systems support the transition to the Year 2000.

      The Company has completed an initial review and assessment of its products
   and, with the exception of the products discussed below, the Company believes
   that its current products are Year 2000 compliant.  For example, the
   Company's core G2 product has two built-in techniques for storing and
   processing time and date information.  These techniques are time stamps and
   intervals.  Time stamps are 64-bit IEEE floating point numbers.  Intervals
   are stored as integers.  Neither of these representations imposes a practical
   limit on the size of the date value stored and do not pose any problems with
   the passing of the millennium.  Therefore, the Company does not believe that
   the Company's products, except those discussed below, will be adversely
   affected by date changes to the Year 2000.  However, there can be no
   assurance that the Company's products contain and will contain all features
   and functionality considered necessary by customers, including ISVs, end
   users and distributors, to be Year 2000 compliant.  In addition, there can be
   no assurances that the Company's current products do not contain undetected
   errors or defects associated with Year 2000 date functions that may result in
   material costs to the Company.

      While the Company believes that current versions of its products are Year
   2000 compliant, other factors may result in an application created using the
   Company's products not being Year 2000 compliant.  Some of these factors
   include improper programming techniques used by third parties in creating the
   application or non-compliance of the underlying hardware, operating system,
   or third-party software on which the software runs.  Known or unknown errors
   or defects in the Company's products could result in delay or loss of
   revenue, diversion of development resources, damage to the Company's
   reputation, or increased service and warranty costs, any of which could
   materially adversely affect the Company's business, operating results or
   financial condition.  Some commentators have predicted significant litigation
   regarding Year 2000 compliance issues, and the Company is aware of such
   lawsuits against other software vendors.  Because of the unprecedented nature
   of such litigation, it is uncertain whether or to what extent the Company may
   be affected by it.

      Testing has revealed that in versions of G2 prior to Rev. 3, a specific G2
   system procedure and the use of two-digit years in the built-in displays are
   not Year 2000 compliant.  These problems were fixed in G2 5.0 Rev. 3 released
   in June 1998.

      The Company's internal systems include both its information technology
   ("IT") and non-IT systems.  The Company completed a baseline assessment of
   its material internal IT systems (including both the Company's own software
   products and third-party software and hardware technology) and its non-IT
   systems.  The Company expects to substantially complete Year 2000 readiness
   preparations by the end of September 1999.  To the extent the Company is not
   able to test the technology provided by third-party vendors, the Company is
   seeking assurances from such vendors that their systems are Year 2000
   compliant.  Although the Company is not currently aware of any material
   operational issues or costs associated with preparing its internal IT and
   non-IT systems for the Year 2000, the Company may experience material
   unanticipated problems and costs caused by undetected errors or defects in
   the technology used in its internal IT and non-IT  systems.  There can be no
   assurance that the Company will not experience unanticipated negative
   consequences or material costs caused by undetected errors or defects in the
   technology used in its internal systems.

      The Company does not in general have information concerning the Year 2000
   compliance status of its customers.  As is the case with other similarly
   situated software companies, if the Company's current or future customers
   fail to achieve Year 2000 compliance, or if they divert technology
   expenditures to address Year 2000 compliance problems, the Company's
   business, results of operations, or financial condition could be materially
   adversely affected.

                                       24
<PAGE>
 
      The Company has funded its Year 2000 plan from operating cash flows and
   has not separately accounted for these costs in the past.  The Company may
   incur additional costs related to the Year 2000 plan for administrative
   personnel to manage the project, outside contractor assistance, technical
   support for its products, product engineering and customer satisfaction.  The
   Company may experience material problems and costs with Year 2000 compliance
   that could adversely affect the Company's business, results of operations,
   and financial condition.

      The Company has not fully developed a comprehensive contingency plan to
   address situations that may result if the Company is unable to achieve Year
   2000 readiness of its initial operations.  The costs of developing and
   implementing such plan may itself be material.  The necessity of a
   contingency plan will be evaluated based on the outcome of its assessment and
   testing of the Year 2000 readiness of material third-parties.  Preparation of
   contingency plans is targeted for May 1999 (which plans will thereafter be
   revised from time to time as deemed appropriate).  Finally, the Company is
   also subject to external forces that might generally affect industry and
   commerce, such as utility company Year 2000 compliance failures and related
   services interruptions.

      The Company expects to complete these assessments and testing, as well as
   the testing of its internal systems, by the end of September 1999, and does
   not anticipate that any of these potential issues will have a material
   adverse effect on the Company's business, financial condition and operating
   results.

      Additionally, there can be no assurance that the Company will not be the
   subject of lawsuits regarding the failure of the Company's products (former
   or present) in the event they are not Year 2000 compliant.  Despite the
   testing and remediation efforts undertaken by the Company, the Company's
   products may contain errors or defects associated with the Year 2000.  Known
   or unknown errors or defects in the Company's products could result in delay
   or loss of revenue, diversion of development resources, damage to the
   Company's reputation or increased service and warranty costs, any of which
   could materially adversely affect the Company's business, operating results
   and financial condition.  In addition, because the computer system in which
   the Company's products are used involve different hardware, software and
   firmware components from different manufacturers, it may be difficult to
   determine which component in a system caused a Year 2000 issue.  As a result,
   the Company may be subjected to Year 2000-related lawsuits independent of
   whether its products are Year 2000 compliant.  Any Year 2000 related suits,
   if adversely determined, could have a material adverse effect on the
   Company's business, operating results and financial conditions.

      The foregoing review of the Company's Year 2000 readiness, including
   estimates of the time frames and costs for addressing the known Year 2000
   issues confronting the Company, is based on management's current estimates,
   which were derived using numerous assumptions.  There can be no assurance
   that these estimates will be achieved and actual events and results could
   differ materially from those anticipated.  Specific factors that might cause
   such material difference include, but are not limited to, the availability of
   personnel with required remediation skills, the ability of the Company to
   identify and correct all relevant computer code and the success of third
   parties with whom the Company does business in addressing their Year 2000
   issues.

   RECENT ACCOUNTING PRONOUNCEMENTS

   In June 1998, the Financial Accounting Standards Board released Statement of
   Financial Accounting Standards No. 133, Accounting for Derivative Instruments
   and Hedging Activities ("SFAS No. 133").  SFAS No. 133 establishes the
   accounting and reporting standards for derivative instruments, including
   certain derivative instruments embedded in other contracts, (collectively
   referred to as derivatives) and for hedging activities.  It requires that an
   entity recognize all derivatives as either assets or liabilities in the
   statement of financial position and measure those instruments at fair value.
   SFAS No. 133 is effective for fiscal quarters beginning after June 15, 1999.
   The Companies does not expect the adoption of SFAS No. 133 to have a material
   impact to its financial position.

   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 Operations Management Systems.
   Substantially all of the Company's revenues are derived from the licensing
   and support of software products that enable organizations to implement
   intelligent operations management systems for decision support and control.
   Although many organizations have begun to deploy, or have announced plans to
   deploy, intelligent operations management 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 operations
   management systems successfully, nor that such systems will gain widespread
   acceptance.  In addition, the timing of the implementation of intelligent
   operations management systems by organizations may be affected by economic
   factors, government regulations, and other factors.  Delays in the
   introduction of intelligent operations management 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 application-specific products and components as well
   as complete solutions, rather than general software tools with which to
   develop application-specific functionality and 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
   satisfy market requirements. 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.

                                       25
<PAGE>
 
      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.

      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.
   Specifically, the Company derives a significant portion of its revenues from
   the chemical and petrochemical industries.  The Company derived 14.5%, 26.8%,
   and 19.7%, of its product revenues in the chemical and petrochemical
   industries in 1998, 1997, and 1996, respectively.  Accordingly, the Company's
   future success is dependent upon the continued demand for process control and
   optimization software from companies in the chemical and petrochemical
   industries.  The Company believes that economic downturns and pricing
   pressures experienced by chemical and petrochemical companies in connection
   with cost-containment measures have led to delays and reductions in certain
   capital and operating expenditures by many such companies worldwide.  These
   industries are highly cyclical and have shown weakened demand in the past,
   which has adversely affected the Company's revenues, gross margin, and
   operating results during such periods. Future recessionary conditions in the
   industries which use the Company's products may 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 operations management 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 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 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 

                                       26
<PAGE>
 
   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 Operations Management Systems."

      Migration to Microsoft Windows and Object Exchange Standards.  The Company
   believes that client user interfaces compliant with Microsoft Windows and
   MOTIF are increasingly the preferred choice of its customers.  In order to
   gain wider customer penetration, the Company must respond to this market
   choice.  Accordingly, the Company is developing and has achieved initial
   commercial release of a client access product that is Microsoft Windows and
   MOTIF compliant.  There can be no assurance that the Company will be
   successful in further developing and marketing 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 and Risks Associated with
   Strategic Partner Relationships.  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 25%,
   35%, and 28% of the Company's product revenues in 1998, 1997, and 1996,
   respectively.  Sales of the Company's products to and by distributors,
   primarily the Company's Japanese distributor, accounted for 3%, 8%, and 14%
   of the Company's product revenues in 1998, 1997, and 1996, 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 47%, 46%, and 42%, of total revenues in
   1998, 1997, and 1996, 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 including the new Euro,
   fluctuating import/export duties and quotas, and unexpected regulatory,
   economic, or political changes in international markets. In particular, the
   continuing economic problems in Asia pose challenges to the Company's sales
   and marketing operations in that region. 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.  In
   all of the Company's markets, there is competition from "point solutions",
   real-time and expert system products,  and internally developed software.  At
   the fundamental level, 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.

      Certain companies such as Objective Systems Integrators, Inc., Micromuse,
   Systems Management Arts (SMARTS), and Pavilion sell "point solutions" that
   compete with the Company's products with respect to specific applications or
   uses. Several companies, including Ilog S.A. and System Management Arts,
   offer products with limited real-time, expert system, or fault isolation
   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.

      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
   reseller, such as cement kiln control and refinery scheduling, and they could
   be successful in supplying alternatives to products based on the Company's
   software.

      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 

                                       27
<PAGE>
 
   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.

      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.  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 current products and systems are Year 2000 compliant, the Company
   utilizes third party equipment and software that may not be Year 2000
   compliant.  Known or unknown errors or defects, with regard to the Year 2000
   and thereafter, in the Company's products and systems could result in delay
   or loss of revenue, diversion of development resources, damage to the
   Company's reputation, increased service and warranty costs, or significant
   litigation, any of which could materially adversely affect the Company's
   business, operating results or 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.

                                       28
<PAGE>
 
   ITEM 7A.  QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

   Investment Portfolio
   --------------------

     The Company does not use derivative financial instruments in its investing
   portfolio.  The Company places its investments in instruments that meet high
   credit quality standards such as money market funds, government securities,
   and commercial paper.  The Company limits the amount of credit exposure to
   any one issuer.  The Company does not expect any material loss with respect
   to its investment portfolio. The following table provides information about
   the Company's investment portfolio.  For investment securities, the table
   presents principal cash flows and related weighted average interest rates by
   expected maturity dates.


            Principal Amounts by Expected Maturity in U. S. Dollars
                        (in 000s, except interest rates)



<TABLE>

                                                                  Investments
                                                Fair Value at     Maturing in
                                                  12/31/98          FY 1999
                                               --------------   ----------------
            <S>                                <C>              <C>    
            Cash Equivalents                     $  11,041           $11,041
            Weighted Average Interest Rate           4.42%              4.42%
                                                                    
            Investments                          $     838           $   838
            Weighted Average Interest Rate           4.04%              4.04%
                                                                    
            Total Portfolio                      $  11,879           $11,879
            Weighted Average Interest Rate           4.39%              4.39%
</TABLE>


   Impact of Foreign Currency Rate Changes
   ---------------------------------------

   During 1998, most currencies in Europe and Asia/Pacific fluctuated, but ended
   the year relatively stable against the U.S. dollar.  However, the translation
   of the parent Company's intercompany receivables and foreign entities,
   assets, and liabilities did not have a material impact on the consolidated
   results of the Company.  The Company does not use foreign exchange forward
   contracts to hedge its foreign currency denominated receivables.  Looking
   forward, there can be no assurance that changes in foreign currency rates,
   relative to the U. S. dollar, will not materially affect the consolidated
   results of the Company.

                                       29
<PAGE>
 
   ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                      GENSYM CORPORATION AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE> 
<CAPTION> 
                                                                                DECEMBER 31,
                                                                      1998                         1997
                                                               -------------------         ---------------------
             ASSETS
<S>                                                            <C>                         <C>  
Current Assets:
   Cash and cash equivalents                                     $13,695,495                   $10,958,102
   Short-term investments                                            838,132                     4,843,247
   Accounts receivable, less reserves of $423,000
     in 1998 and $354,000 in 1997                                  7,578,272                     8,310,838
   Prepaid expenses                                                1,774,687                     1,565,099
   Deferred income taxes                                           1,547,991                     1,160,276
                                                               -------------              ----------------
     Total current assets                                         25,434,577                    26,837,562
                                                               -------------               ---------------      
Property and Equipment, at cost
   Computer equipment and software                                 8,042,652                     7,373,221
   Furniture and fixtures                                          1,788,170                     1,697,510
   Leasehold improvements                                            490,035                       407,247
                                                               -------------               ---------------
                                                                  10,320,857                     9,477,978
Accumulated depreciation and amortization                         (8,339,137)                   (7,093,939)
                                                               -------------               ---------------
                                                                   1,981,720                     2,384,039
                                                               -------------               ---------------
Long-term investments                                                      -                     1,040,855
Long-term deferred income taxes                                      612,285                     1,000,000
Deposits and other assets                                            239,180                       254,651
                                                               -------------               ---------------
                                                                 $28,267,762                   $31,517,107
                                                               =============               ===============
             LIABILITIES AND STOCKHOLDERS' EQUITY
 
Current Liabilities:
   Accounts payable                                              $   516,629                   $   914,002
   Accrued expenses                                                3,862,219                     4,975,813
   Deferred revenue                                                6,405,603                     5,798,927
                                                               -------------               ---------------
     Total current liabilities                                    10,784,451                    11,688,742
                                                               -------------               ---------------
  
Commitments (Note 5)
Stockholders' Equity:
   Preferred Stock, $.01 par value - 
     Authorized 2,000,000 shares 
     Issued and outstanding - none                                         -                             -
   Common Stock, $.01 par value 
     Authorized - 20,000,000 shares 
     Issued - 6,557,268 shares
     in 1998 and 6,409,397 shares in 1997                             65,573                        64,094
   Capital in excess of par value                                 20,426,908                    19,940,717
   Treasury stock -345,200 shares in 1998, at cost                (1,278,439)                            -
   Retained earnings                                              (1,101,134)                      386,878
   Cumulative translation adjustment                                (629,597)                     (563,324)
                                                               -------------               ---------------
     Total stockholders' equity                                   17,483,311                    19,828,365
                                                               -------------               ---------------
                                                                 $28,267,762                   $31,517,107
                                                               =============               ===============
</TABLE> 
 
The accompanying notes are an integral part of these consolidated financial
statements.

                                       30
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE> 
<CAPTION> 
                                                                      YEAR ENDED DECEMBER 31,
                                                              1998             1997             1996
                                                        ------------------------------------------------
<S>                                                        <C>              <C>              <C> 
REVENUES:
  Product                                                  $16,910,670      $18,433,520      $21,358,295
  Service                                                   18,067,035       17,075,603       15,877,240
                                                        ------------------------------------------------
     Total revenues                                         34,977,705       35,509,123       37,235,535
 
COST OF REVENUES                                             8,697,594        9,352,348        7,385,215
                                                        ------------------------------------------------
Gross profit                                                26,280,111       26,156,775       29,850,320
                                                        ------------------------------------------------
OPERATING EXPENSES:
  Sales and marketing                                       18,275,852       18,802,113       17,432,861
  Research and development                                   6,022,931        6,977,143        5,983,741
  General and administrative                                 4,133,849        4,528,147        3,699,254
  Restructuring charge                                               -        1,557,253                -
                                                        ------------------------------------------------
     Total operating expenses                               28,432,632       31,864,656       27,115,856
                                                        ------------------------------------------------
Operating income (loss)                                     (2,152,521)      (5,707,881)       2,734,464
 
OTHER INCOME:
  Interest income                                              677,876          590,659          607,761
  Other income (expense)                                        36,633          188,459          (90,003)
                                                        ------------------------------------------------
     Total other income, net                                   714,509          779,118          517,758
                                                        ------------------------------------------------
 
Income (loss) before provision for income taxes             (1,438,012)      (4,928,763)       3,252,222
 
PROVISION FOR INCOME TAXES                                      50,000           40,000        1,204,000
                                                        ------------------------------------------------

Net income (loss)                                          $(1,488,012)     $(4,968,763)     $ 2,048,222
                                                        ================================================

Basic income (loss) per share                                   $(0.23)          $(0.79)           $0.35
                                                        ================================================

Diluted income (loss) per share                                 $(0.23)          $(0.79)           $0.33
                                                        ================================================

Weighted average common shares outstanding - Basic           6,371,190        6,309,815        5,909,511
                                                        ================================================
                                                     
Weighted average common shares outstanding - Diluted         6,371,190        6,309,815        6,286,170
                                                        ================================================
</TABLE> 
 
The accompanying notes are an integral part of these consolidated financial
statements.
                                        

                                       31
<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           $0.10         Number        $0.10         Number       $0.01 Par 
                                             of Shares       Par Value     of Shares     Par Value     of Shares        Value   
                                           -----------    -------------  ------------   ------------- -----------  --------------
<S>                                        <C>             <C>             <C>           <C>           <C>           <C>  
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                                          --               --             --            --            --            --
Comprehensive net income for the year ended                                                                                     
     December 31, 1996                                                                                                          
                                           -----------       ----------      ---------     ---------    ----------    ---------- 
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                                            --               --             --            --            --            -- 
Comprehensive net loss for the year ended                                                                                       
     December 31, 1997                                                                                                          
                                           -----------       ----------      ---------     ---------    ----------    ---------- 
BALANCE, DECEMBER 31, 1997                          --               --             --            --     6,409,397        64,094
Exercise of Stock Options                           --               --             --            --        18,050           181
Issuance of common stock under ESPP                 --               --             --            --       129,821         1,298
Treasury stock--345,200 shares                      --               --             --            --            --            --
Translation adjustment                              --               --             --            --            --            -- 
Net loss                                            --               --             --            --            --            -- 
Comprehensive net loss for the year ended                                                                                       
     December 31, 1998                     -----------       ----------      ---------     ---------    ----------    ----------
BALANCE, DECEMBER 31, 1998                          --               --             --            --     6,557,268       $65,573
                                           ===========       ==========      =========     =========    ==========    ==========
<CAPTION> 
                                                              Capital in                   Cumulative       Total                 
                                                 Treasury     Excess of     Retained       Translation  Stockholders' Comprehensive
                                                  Stock       Par Value     Earnings       Adjustment       Equity    Income (Loss)
                                              ------------   -----------  -----------     ------------  ------------- -------------
<S>                                           <C>          <C>            <C>           <C>             <C>           <C>          
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)        (40,374)
Net income                                         --               --      2,048,222            --       2,048,222       2,048,222
                                                                                                                      -------------
Comprehensive net income for the year ended                                                                         
     December 31, 1996                                                                                                    2,007,848
                                              -----------  -----------     ----------   -----------     -----------   =============
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)       (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)     (4,968,763)
                                                                                                                      -------------
Comprehensive net loss for the year ended                                                                                          
     December 31, 1997                                                                                                   (5,455,560)
                                               ----------  -----------     ----------   ------------    -----------   =============
BALANCE, DECEMBER 31, 1997                         --       19,940,717        386,878      (563,324)     19,828,365                
Exercise of Stock Options                          --           82,469             --            --          82,650                
Issuance of common stock under ESPP                --          403,722             --            --         405,020                
Treasury stock--345,200 shares                 (1,278,439)          --             --            --      (1,278,439)               
Translation adjustment                             --               --             --       (66,273)        (66,273)        (66,273)
Net loss                                           --               --     (1,488,012)   (1,488,012)             --      (1,488,012)
                                                                                                                      -------------
Comprehensive net loss for the year ended                                                                                          
     December 31, 1998                                                                                                $  (1,559,285)
                                            -------------  -----------    -----------   -----------     -----------   =============
BALANCE, DECEMBER 31, 1998                    $(1,278,439) $20,426,908    $(1,101,134)  $  (629,597)    $17,483,311          
                                           ==============  ===========    ===========   ===========     ===========          
</TABLE> 

                                       32
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
    

<TABLE> 
<CAPTION> 
                                                                                            YEAR ENDED DECEMBER 31,
                                                                               1998                   1997                   1996
                                                                        ----------------       ----------------       -------------
<S>                                                                    <C>                    <C>                    <C>    
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income                                                      $(1,488,012)           $(4,968,763)           $ 2,048,222
Adjustments to reconcile net (loss) income to net cash  
 (Used in) provided by operating activities:            
     Depreciation and amortization                                       1,245,198              1,147,112              1,087,658
     Deferred income taxes                                                       -               (500,000)              (637,325)
     Restructuring charge                                                        -                842,251                      -
     Changes in assets and liabilities:                 
        Accounts receivable                                                747,081              1,375,274             (1,481,427)
        Prepaid expenses                                                  (214,119)                15,845               (691,719)
        Accounts payable                                                  (399,829)              (314,597)               242,060
        Accrued expenses                                                (1,155,348)              (490,261)             1,902,329
        Deferred revenue                                                   610,805                (10,556)             1,398,857
                                                                  ----------------       ----------------       ----------------
        Net cash (used in) provided by operating activities               (654,224)            (2,903,695)             3,868,655
                                                                  ----------------       ----------------       ----------------
  
CASH FLOWS FROM INVESTING ACTIVITIES:
     Sales (purchases) of short-term investments                         4,005,115              3,067,702             (4,945,007)
     Sales (purchases) of long-term investments                          1,040,855               (298,680)              (742,175)
     Purchases of property and equipment                                  (842,880)            (1,187,042)            (1,562,217)
     Decrease (increase) in deposits and other assets                       32,595                (80,330)                37,391
                                                                  ----------------       ----------------       ----------------
     Net cash (used in) provided by investing activities                 4,235,685              1,501,650             (7,212,008)
                                                                  ----------------       ----------------       ----------------
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
     Purchases of treasury stock                                        (1,278,439)                     -                      -
     Proceeds from exercise of stock options                                82,650                500,951                612,890
     Proceeds from issuance of Common Stock under employee
           stock purchase plan                                             405,020                633,112                326,749
     Proceeds from initial public offering, net of 
           issuance costs                                                        -                      -             11,952,391 
                                                                  ----------------       ----------------       ----------------
     Net cash (used in) provided by financing activities                  (790,769)             1,134,063             12,892,030
                                                                  ----------------       ----------------       ----------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH                                    (53,299)              (452,819)                 3,967
                                                                  ----------------       ----------------       ----------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                     2,737,393               (720,801)             9,552,644
 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                          10,958,102             11,678,903              2,126,259
                                                                  ----------------       ----------------       ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD                               $13,695,495            $10,958,102            $11,678,903
                                                                  ================       ================       ================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
     Cash paid during the period for -
            Income taxes                                               $   423,879            $   445,242            $   608,805
                                                                  ================       ================       ================
</TABLE> 

 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                       33
<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, 1998. 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, 1998 and 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:

                                                       Estimated
                    Asset Classification              Useful Lives
                    --------------------              ------------
                    Computer equipment
                      and software.................   3 Years
                    Furniture and fixtures.........   5 Years
                    Leasehold improvements.........   Shorter of lease term or
                                                      useful life

   (D) REVENUE RECOGNITION

       Product revenues are recognized upon shipment or upon the completion of
       all significant obligations by the Company, whichever is later, provided
       that the fee is fixed or determinable and deemed collectible by
       management. If conditions for acceptance are required subsequent to
       delivery, revenues are recognized upon customer acceptance. 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. Revenues derived from consulting and
       training are recognized upon performance of the services provided that
       the amounts due from customers are fixed or determinable and deemed
       collectible by management. 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 has adopted 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
       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.

                                       34
<PAGE>
 
 (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 $316,000 and $314,000 for the years ended
     December 31, 1998 and 1997, respectively.  There were no Company
     contributions for the year ended December 31, 1996.

 (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 1998, 1997, or
     1996.  No single customer accounted for greater than 10% of accounts
     receivable during 1998 or 1997.  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

     In accordance with SFAS No. 128, Earnings per Share, 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 potential common shares outstanding during the periods in
     accordance with the treasury stock method.  For the years ended December
     31, 1998 and 1997, the computation for diluted loss per share excludes the
     effect of 31,066 shares and 81,872 shares, respectively, shares issuable
     from assumed exercise of options, as their effect would be antidilutive.
     The weighted average common shares outstanding, assuming dilution, for the
     year ended December 31, 1996 includes 376,659 potential common shares from
     the assumed exercise of options.

 (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.

 (L) NEW ACCOUNTING PRONOUNCEMENT

     In June 1998, the Financial Accounting Standards Board released Statement
     of Financial Accounting Standards No. 133, Accounting for Derivative
     Instruments and Hedging Activities ("SFAS No. 133").  SFAS No. 133
     establishes the accounting and reporting standards for derivative
     instruments, including certain derivative instruments embedded in other
     contracts, (collectively referred to as derivatives) and for hedging
     activities.  It requires that an entity recognize all derivatives as either
     assets or liabilities in the statement of financial position and measure
     those instruments at fair value. SFAS No. 133 is effective for fiscal
     quarters beginning after June 15, 1999. The Company does not expect the
     adoption of SFAS No. 133 to have a material impact to its financial
     position.

   (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 (7.75% as
   of December 31, 1998).  The line of credit expires on April 30, 2000 and
   requires the Company to comply with certain financial ratios, including
   minimum levels 

                                       35
<PAGE>
 
   of net worth and profitability. The Company obtained a waiver from the bank
   with respect to the Company not satisfying the profitability and net worth
   covenant as of December 31, 1998. As of December 31, 1998, there were no
   borrowings outstanding under the line of credit.

 (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.

 (C) SERIES A AND SERIES B CONVERTIBLE PREFERRED STOCK

     The Series A and Series B Convertible Preferred Stock were converted into
     shares of Common Stock upon the closing of the Company's initial public
     offering in February 1996.

 (D) STOCK OPTION PLANS

     The following table shows the Company's stock option plans, the number of
     shares reserved for issuance by the Company's Board of Directors, and the
     number of shares available for future issuance as of December 31, 1998:


<TABLE>
<CAPTION>
                                                                             Number of Shares
                                                                              Available for
                                                                             Future Issuance
                                                  Number of Shares            as of December
                        Plan Name               Reserved for Issuance            31, 1998
          ------------------------------        ---------------------       -------------------
          <S>                                     <C>                         <C>
          1987 Stock Plan                                     600,000                         0
          1994 Stock Option Plan                              534,850                   170,350
          1995 Director Stock Option Plan                     500,000                   216,047
          1997 Stock Incentive Plan                           100,000                    78,000
                                                            ---------                   -------
                                                            1,734,850                   464,397
                                                            =========                   =======
</TABLE>


     The 1987 Stock Plan provided for the grant of incentive stock options,
     nonqualified stock options, stock awards, and direct sales of stock.  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 1997 Stock
     Incentive Plan provides for the grant of incentive stock options,
     nonqualified stock options, restricted stock and other stock-based awards.
     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. 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 Board of Directors, on October 22, 1998, authorized the repricing of
     certain incentive stock options.  Under the repricing plan, option holders
     were permitted to voluntarily exchange their old options for new options.
     The new options allow the option holders to purchase 80% of the number of
     shares of Common Stock represented by the old options at a price equal to
     the closing price of the Company's Common Stock, or for officers, at a
     price equal to 110% of the closing price, on November 20, 1998.  All other
     terms and conditions of the new options remain identical to the old options
     agreement.  The closing price of the Common Stock on November 20, 1998 was
     $3.88.  Under the repricing plan, 670,160 incentive stock options were
     cancelled and 539,948 incentive stock options were reissued.

     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 Common Stock of the
     Company to non-employee directors of the Company.  Upon completion of the
     initial public offering of the Company's Common Stock, each non-employee

                                       36
<PAGE>
 
     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 is 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
     option plans for the three years ended December 31, 1998:

<TABLE>
<CAPTION>
                                                                 Number                 Option Price            Weighted Average
                                                               of Shares                  per Share              Exercise Price
                                                        ---------------------        -----------------       ---------------------
           <S>                                            <C>                          <C>                     <C>
           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
           Granted                                                    835,698              3.00 - 7.50                        4.94
           Exercised                                                  (18,050)             1.60 - 7.50                        4.58
           Canceled                                                  (907,789)            3.81 - 20.00                        6.90
                                                        ---------------------        -----------------       ---------------------
           Outstanding at December 31, 1998                           729,639           $3.00 - $10.00                      $ 4.44
                                                        =====================        =================       =====================
           Exercisable at December 31, 1998                           250,366           $3.00 - $10.00                      $ 4.59
                                                        =====================        =================       =====================
</TABLE>


    The range of exercise prices for options outstanding and options exercisable
    at December 31, 1998 is as follows:


<TABLE>
<CAPTION>
                                                                 OPTIONS OUTSTANDING                     OPTIONS EXERCISABLE
                                                    -----------------------------------------  --------------------------------
                                                                                                                   Weighted     
                                                        Weighted Average      Weighted                             Average      
                                       Options            Remaining            Average            Options          Exercise     
    Range of  Exercise Prices        Outstanding       Contractual Life     Exercise Price       Exercisable         Price      
 ------------------------------    -----------     --------------------  ------------------   -----------------  --------------
 <S>                               <C>             <C>                   <C>                  <C>                <C> 
           $  3.00-4.50              581,589              7.00                  $3.98            195,856              $3.96     
           $  4.63-6.50               82,130              8.19                   5.11             19,090               5.35     
           $ 7.50-10.00               65,920              7.96                   7.65             35,420               7.67     
                                  ----------         ---------             ----------        -----------        -----------    
                                     729,639              7.22                  $4.44            250,366              $4.59     
                                  ===========        =========             ==========        ===========        ===========     
</TABLE>

     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
     Common Stock to participating employees.  In January 1998 the board of
     directors amended the Purchase Plan to increase the number of shares of
     Common Stock reserved for issuance under the Plan from 200,000 to 500,000.

     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
     291,900 shares as of December 31, 1998.

                                       37
<PAGE>
 
(E)  STOCK-BASED COMPENSATION

     The Company has computed the pro forma disclosure required under SFAS No.
     123 for all stock compensation plans during the three years ended December
     31, 1998, 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>
                                                                          1998                  1997                 1996
                                                                   ----------------     -----------------    ------------------
                          <S>                                      <C>                  <C>                  <C>
                          Risk-free interest rate                       4.65 - 5.71%          5.46 - 6.71%          5.47 - 6.88%
                          Expected dividend yield                                 0                     0                     0
                          Expected lives of option grants                 7.0 Years             6.5 Years             6.5 Years
                          Expected volatility                                    70%                   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>
                                                                              1998                  1997                  1996
                                                                       ----------------     ------------------    ------------------
            <S>                                                        <C>                  <C>                   <C>
            Net income (loss) as reported                                   $(1,488,012)           $(4,968,763)           $2,048,222
            Pro forma net income (loss) as adjusted                          (2,384,191)            (5,615,312)            1,736,170
            Diluted income (loss) per share as reported                          ($0.23)                ($0.79)           $     0.33
            Pro forma diluted income (loss) per share as adjusted                ($0.43)                ($0.95)           $     0.28
</TABLE>

     The estimated weighted average fair value of options granted during 1998,
     1997, and 1996 was $3.25, $3.95, and $8.48 per share, respectively.  The
     estimated weighted average fair values of grants made under the Purchase
     Plan during 1998, 1997, and 1996 was $1.97, $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, 1998, the weighted average remaining life of outstanding stock
     options was 7.22 years.

   (F) STOCK REPURCHASE PROGRAM

       In the third quarter of 1998, the Company began a program to repurchase
   up to 650,000 shares of its Common Stock on the open market. As of December
   31, 1998, 345,200 shares had been repurchased at a cost of $1,278,000.

   (4) INCOME TAXES

       The components of the provision for income taxes for the three years
   ended December 31, 1998 are as follows:

<TABLE>
<CAPTION>
                                                  1998                    1997                     1996
                                          -----------------       ------------------       -----------------
     <S>                                  <C>                     <C>                      <C>
     Federal                          
          Current                                 $ (70,898)             $   (90,638)             $  758,694
          Deferred                                 (675,074)              (2,221,471)               (122,463)
                                          -----------------       ------------------       -----------------
                                                   (745,972)              (2,312,109)                636,231
                                          -----------------       ------------------       -----------------
     State                            
          Current                                     7,313                    6,428                 252,898
          Deferred                                  (31,244)                 (27,620)                (40,821)
                                          -----------------       ------------------       -----------------
                                                    (23,931)                 (21,192)                212,077
                                          -----------------       ------------------       -----------------
     Foreign                          
          Withholding                                47,584                  181,617                 443,000
          Income                                     66,000                  524,000                 386,733
                                          -----------------       ------------------       -----------------
                                                    113,584                  705,617                 829,733
                                          -----------------       ------------------       -----------------
                                      
     Change in Valuation Allowance                  706,319                1,667,684                (474,041)
                                          -----------------       ------------------       -----------------
                                      
                                                  $  50,000              $    40,000              $1,204,000
                                          =================       ==================       =================
</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.

                                       38
<PAGE>
 
   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>
                                                                                         1998                     1997
                                                                                  ----------------         ----------------
          <S>                                                                     <C>                      <C>
          Net operating loss carryforward                                              $ 2,299,149              $ 2,138,450
          Research and development tax credit carryforward                               1,017,783                  715,871
          Depreciation                                                                     122,058                  136,500
          Deferred revenue                                                                 316,679                  451,984
          Other temporary differences                                                      778,610                  385,155
                                                                                  ----------------         ----------------
                                                                                         4,534,279                3,827,960
          Valuation allowance                                                           (2,374,003)              (1,667,684)
                                                                                  ----------------         ----------------
          Net deferred tax asset                                                       $ 2,160,276              $ 2,160,276
                                                                                  ================         ================
</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.

   The provision for income taxes differs from the amount computed by applying
   the statutory federal income tax rate as follows:

<TABLE>
<CAPTION>
                                                                    1998                     1997                   1996
                                                             ---------------         ----------------         -------------
          <S>                                                <C>                     <C>                      <C>
          Provision at federal statutory rate                          (34.0)  %                (34.0)  %             34.0 %
          State income tax, net of federal benefits                     (1.1)                    (0.4)                  4.3
          Foreign income and withholding taxes                          27.9                      6.6                  19.6
          Change in valuation allowance                                 49.1                     33.8                 (14.6)
          Utilization of tax credits                                   (21.0)                    (0.4)                 (9.5)
          Other, net                                                   (17.4)                    (4.8)                  3.2
                                                             ---------------         ----------------         -------------
                                                                         3.5%                    0.8 %                37.0 %
                                                             ===============         ================         =============
</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,
   1998 are as follows:

<TABLE>
<CAPTION>
                              Year                      Amount
                           -----------            ----------------
                           <S>                    <C> 
                              1999                 $     2,905,000
                              2000                       2,548,000
                              2001                         963,000
                              2002                         476,000
                              2003                         230,000
                            Thereafter                     191,000
                                                  ----------------
                                                   $     7,313,000
                                                  ================
</TABLE>

   Rent expense recorded by the Company under the above leases, net of rental
   income from sub-leases, for the years ended December 31, 1998, 1997 and 1996
   were approximately $2,931,000, $3,834,000, and $3,102,000, respectively.

                                       39
<PAGE>
 
   (6) ACCRUED EXPENSES

   Accrued expenses consist of the following:

<TABLE>
<CAPTION>
                                                                                   1998                  1997
                                                                            ----------------      ----------------
                   <S>                                                      <C>                   <C>
                   Accrued payroll and related expenses                           $1,099,554            $1,033,397
                   Accrued commissions                                               460,518               800,000
                   Other accrued expenses                                          2,302,147             3,142,416
                                                                            ----------------      ----------------
                                                                                  $3,862,219            $4,975,813
                                                                            ================      ================
</TABLE>

   (7) RESTRUCTURING CHARGE

   During the second quarter of 1997, the Company recorded a charge of
   approximately $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 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.

   As of December 31, 1998, approximately $60,000 of accrued restructuring
   charges pertaining to future rent payment obligations are expected to be paid
   during 1999.

                                       40
<PAGE>
 
   (8) FINANCIAL INFORMATION BY GEOGRAPHIC AREA

   Domestic and international sales as a percentage of total revenues are as
   follows:

<TABLE>
<CAPTION>
                              1998             1997            1996
                           ----------       ----------      ------------
      <S>                  <C>              <C>             <C>
      United States                53%              54%               58%
      Europe                       27               30                24
      Other                        20               16                18
                           ----------       ----------      ------------
                                  100%             100%              100%
                           ==========       ==========      ============
</TABLE>

   (9) SEGMENT REPORTING

   On December 31, 1998, Gensym adopted SFAS No. 131, Disclosure about Segments
   of an Enterprise and Related Information.  This pronouncement established
   standards for public companies relating to the reporting of financial and
   descriptive information about their operating segments in financial
   statements.  Operating segments are defined as components of an enterprise
   about which separate financial information is available that is evaluated
   regularly by management in deciding how to allocate resources and in
   assessing performance of the business.

   The Company has historically evaluated its operations in three geographical
   segments: Americas, Europe/Middle East/Africa, and Asia-Pacific.

   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 value-added resellers and systems integrators, who provide
   consulting services and integrated solutions to their customers.  The Company
   further licenses technology to OEMs, who embed the technology within their
   product offerings.

   The accounting policies of the segments are the same as those described in
   Note 1.  The Company evaluates performance of its segments based on revenues
   and segment profitability.  Segment profitability is defined by the Company
   as gross contribution, which is computed based on gross profit less
   identifiable operating costs--principally sales and marketing costs.
   Information as to the operations of the different segments is set forth
   below:

<TABLE>
<CAPTION>
                                                                          (in thousands)

                                                                       Europe,       
                                                                     Middle East,
                                                 Americas              & Africa              Asia-Pacific               Total
                                            ----------------       ----------------      ------------------      -----------------
   <S>                                      <C>                    <C>                   <C>                     <C>
   Year ended December 31, 1998:            
        Revenues                               $      22,431           $     10,196           $       2,351          $      34,978
                                            ================      =================      ==================      ================= 
        Gross contribution                     $       9,952           $      2,186           $        (206)         $      11,932
                                            ================      =================      ==================      ================= 
        Identifiable assets                    $      23,864           $      3,941           $         462          $      28,267
                                            ================      =================      ==================      ================= 
                                                                                                                           
   Year ended December 31, 1997:                                                                                           
        Revenues                               $      21,212           $     11,293           $       3,004          $      35,509
                                            ================      =================      ==================      ================= 
        Gross contribution                     $       8,674           $      4,155           $         335          $      13,163
                                            ================      =================      ==================      ================= 
        Identifiable assets                    $      28,170           $      2,851           $         496          $      31,517
                                            ================      =================      ==================      =================
                                                                                                                           
   Year ended December 31, 1996:                                                                                           
        Revenues                               $      23,451           $      9,369           $       4,416          $      37,236
                                            ================      =================      ==================      ================= 
        Gross contribution/1/                                                                                              
                                            ================      =================      ==================      ================= 
        Identifiable assets                    $      33,065           $      2,700           $         493          $      36,258
                                            ================      =================      ==================      =================
</TABLE> 

   /1/ This information has not been provided as it would be impracticable to do
       so.
                                       41
<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, 1998
   and 1997, and the related consolidated statements of operations,
   stockholders' equity, and cash flows for each of the three years in the
   period ended December 31, 1998.  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, 1998 and 1997, and the results of their
   operations and their cash flows for each of the three years in the period
   ended December 31, 1998, in conformity with generally accepted accounting
   principles.

                                          /s/ ARTHUR ANDERSEN LLP
                                          -----------------------
                                              ARTHUR ANDERSEN LLP

   Boston, Massachusetts
   February 1, 1999

                                       42
<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 (the "Proxy Statement"), to be mailed in April
   1999, for the Annual Meeting of Stockholders to be held on Friday, May 21,
   1999 at 10:00 A.M. at the offices of Hale and Dorr LLP, 60 State Street,
   Boston, MA 02109. 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.

                                       43
<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, 1998 and 1997
   Consolidated Statements of Operations for the three years ended December 31,
   1998
   Consolidated Statements of Stockholders' Equity for the three years ended
   December 31, 1998
   Consolidated Statements of Cash Flows for the three years ended December 31,
   1998
   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, 1998

                                       44
<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)      



                                        By:  /s/ Lowell B. Hawkinson
                                             ----------------------- 
   Dated:  March 25, 1999                    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 22, 1999:

   /s/ Lowell B. Hawkinson
   -----------------------
   Lowell B. Hawkinson                       Chairman, Chief Executive Officer,
                                             Director, and Treasurer
                                             (Principal Executive Officer, 
                                             Principal Financial Officer, and
                                             Principal Accounting Officer)

   /s/ Robert L. Moore
   -------------------
   Robert L. Moore                           President and Director

   /s/ John A. Shane
   -----------------
   John A. Shane                             Director

   /s/ Theodore Johnson
   --------------------
   Theodore Johnson                          Director

   /s/ Thomas E. Swithenbank
   -------------------------
   Thomas E. Swithenbank                     Director

   /s/ Barry R. Gorsun
   --------------------
   Barry R. Gorsun                           Director

                                       45
<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 February 1, 1999.  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
   February 1, 1999

                                       46
<PAGE>
 
                              GENSYM CORPORATION
               SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
          FOR THE THREE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
 
 
<TABLE> 
<CAPTION> 
                                             Balance at             Addition                          Balance at
                                            Beginning of           Charged to                           End of
Description                                    Period               Expense          Deductions         Period
-----------                               ----------------       --------------    --------------    -------------
<S>                                       <C>                    <C>               <C>                <C> 
ALLOWANCE FOR DOUBTFUL ACCOUNTS:                                                                     
                                                                                                     
Year ended December 31, 1998                 $     354,205          $   110,000       $    41,645       $  422,560 
                                          ================       ==============    ==============    ============= 
                                                                                                                   
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 
                                          ================       ==============    ==============    ============= 
</TABLE>

                                       47
<PAGE>
 
EXHIBIT INDEX

Exhibit #      Description
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 (Incorporated by 
               reference to the Registrant's Proxy Statement filed on 
               April 6, 1998)
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)
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


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