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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

|   |  |                                                                                         
|-- |  | ----------------------------------------------------------------------------------------
|x  |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 
|  
|   |  | For the quarterly period ended June 30, 2002                                            
|  
|OR
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from __________________________________ to __________________________________

Commission File Number

INTERNET SECURITY SYSTEMS, INC.




(Exact name of registrant as specified in its charter)


|                                                         |  |                                     
|-------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                 |  | 58-2362189                          
|                                                         |  |                                     
|(State or jurisdiction of
incorporation or organization) |  | (I.R.S. Employer
Identification No.)

6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328




(Address of principal executive offices)


Registrants telephone number, including area code
(404) 236-2600

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   o

Indicate the number of shares outstanding of each of the registrants
classes of common stock, as of the latest practicable date.

|                               |  |                                                  
|------------------------------ |  | -------------------------------------------------
|Title of each class            |  | Number of Shares Outstanding
as of August 2, 2002
|                               |  |                                                  
|Common Stock, $0.001 par value |  | 48,397,377                                       





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|                                     |                                                                                       |                                            |  |  |  |  |  | 
|------------------------------------ | ------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|                                     |                                                                                       | CONSOLIDATED BALANCE SHEETS               
|                                     |                                                                                       | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                                     |                                                                                       | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                                     |                                                                                       | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                                     | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                                     | ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                   
|PART II OTHER INFORMATION           
|                                     | ITEM 1. LEGAL PROCEEDINGS                                                            
|                                     | ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS                                    
|                                     | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                          
|                                     | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                             
|Section 906 Certification of the CEO
|Section 906 Certification of the CFO



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|                                                                                             |                                                                                                                 |  |        |  |    |   |  |  | 
|-------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------- |  | ------ |  | -- | - |  |  | 
|                                                                                             |                                                                                                                 |  | PAGE  
|                                                                                             |                                                                                                                 |  | NUMBER
|                                                                                             |                                                                                                                 |  |       
|PART I. FINANCIAL INFORMATION                                                                |                                                                                                                 |  |        |  |    |   |  | 
|Item 1 Consolidated Financial Statements:                                                    |                                                                                                                 |  |        |  |    |   |  | 
|                                                                                             | Consolidated Balance Sheets at June 30, 2002 and
December 31, 2001                                              |  |        |  |    | 3 |  |  | 
|                                                                                             | Consolidated Statements of Operations for the three months
and six months ended June 30, 2002 and June 30, 2001 |  |        |  |    | 4 |  |  | 
|                                                                                             | Consolidated Statements of Cash Flows for the six
months ended June 30, 2002 and June 30, 2001                  |  |        |  |    | 5 |  |  | 
|                                                                                             | Notes to Consolidated Financial Statements                                                                      |  |        |  |    | 6 |  |  | 
|Item 2 Managements Discussion and Analysis of
Financial Condition and Results of Operations |                                                                                                                 |  |        |  | 9  |   |  | 
|Item 3 Quantitative and Qualitative Disclosures about Market Risk                            |                                                                                                                 |  |        |  | 21 |   |  | 
|PART II. OTHER INFORMATION                                                                   |                                                                                                                 |  |        |  | 21 |   |  | 
|Item 1
Legal Proceedings                                                                     |                                                                                                                 |  |        |  | 21 |   |  | 
|Item 2
Changes in Securities and Use of Proceeds                                             |                                                                                                                 |  |        |  | 21 |   |  | 
|Item 4
Submission of Matters to a Vote of Security Holders                                   |                                                                                                                 |  |        |  | 21 |   |  | 
|Item 6 Exhibits and Reports on Form 8-K                                                      |                                                                                                                 |  |        |  | 22 |   |  | 

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INTERNET SECURITY SYSTEMS, INC.




CONSOLIDATED BALANCE SHEETS


(Amounts in thousands, except per share amounts)


|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |         |         | 
|----------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ----------- | ------- | ------------ | ------- | ------- | ------- | 
|                                                                                    |                                                                                                                              |                                            |         | June 30,    |         | December 31,
|                                                                                    |                                                                                                                              |                                            |         | 2002        |         | 2001        
|                                                                                    |                                                                                                                              |                                            |         |             |         |             
|                                                                                    |                                                                                                                              |                                            |         | (UNAUDITED) |         |              |         |        
|ASSETS                                                                              |                                                                                                                              |                                            |         |             |         |              |         |        
|Current assets:                                                                     |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    | Cash and cash equivalents                                                                                                    |                                            | $       | 141,282     |         |              | $       | 108,038 |        
|                                                                                    | Marketable securities                                                                                                        |                                            |         | 32,697      |         |              |         | 55,129  |        
|                                                                                    | Accounts receivable, less allowance for doubtful accounts
of $2,485 and $2,563, respectively                                 |                                            |         | 55,767      |         |              |         | 50,259  |        
|                                                                                    | Inventory                                                                                                                    |                                            |         | 2,156       |         |              |         | 1,768   |        
|                                                                                    | Prepaid expenses and other current assets                                                                                    |                                            |         | 6,885       |         |              |         | 6,018   |        
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              | Total current assets                       |         |             | 238,787 |              |         |         | 221,212 | 
|Property and equipment:                                                             |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    | Computer equipment                                                                                                           |                                            |         | 34,874      |         |              |         | 31,043  |        
|                                                                                    | Office furniture and equipment                                                                                               |                                            |         | 22,572      |         |              |         | 20,872  |        
|                                                                                    | Leasehold improvements                                                                                                       |                                            |         | 20,219      |         |              |         | 17,835  |        
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              |                                            | 77,665  |             |         |              | 69,750  |        
|                                                                                    | Less accumulated depreciation                                                                                                |                                            |         | 32,399      |         |              |         | 25,254  |        
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              |                                            | 45,266  |             |         |              | 44,496  |        
|Restricted marketable securities                                                    |                                                                                                                              |                                            | 12,500  |             |         |              | 12,500  |        
|Goodwill, less accumulated amortization of $27,381                                  |                                                                                                                              |                                            | 196,884 |             |         |              | 197,060 |        
|Other intangibles, less accumulated amortization of
$6,901 and $4,644, respectively |                                                                                                                              |                                            | 16,513  |             |         |              | 19,722  |        
|Other assets                                                                        |                                                                                                                              |                                            | 8,119   |             |         |              | 5,994   |        
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              | Total assets                               |         | $           | 518,069 |              |         | $       | 500,984 | 
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|LIABILITIES AND STOCKHOLDERS EQUITY                                                |                                                                                                                              |                                            |         |             |         |              |         |        
|Current liabilities:                                                                |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    | Accounts payable                                                                                                             |                                            | $       | 2,103       |         |              | $       | 3,553   |        
|                                                                                    | Accrued expenses                                                                                                             |                                            |         | 19,681      |         |              |         | 20,440  |        
|                                                                                    | Deferred revenues                                                                                                            |                                            |         | 48,812      |         |              |         | 48,139  |        
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              | Total current liabilities                  |         |             | 70,596  |              |         |         | 72,132  | 
|Other non-current liabilities                                                       |                                                                                                                              |                                            | 1,809   |             |         |              | 1,917   |        
|Commitments and contingencies                                                       |                                                                                                                              |                                            |         |             |         |              |         |        
|Stockholders equity:                                                               |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    | Preferred stock, $.001 par value, 20,000,000 shares authorized,
none issued or outstanding                                   |                                            |         |            |         |              |         |        |        
|                                                                                    | Common stock, $.001 par value, 120,000,000 shares authorized,
48,386,000 and 47,871,000 issued and outstanding, respectively |                                            |         | 48          |         |              |         | 48      |        
|                                                                                    | Additional paid-in capital                                                                                                   |                                            |         | 438,338     |         |              |         | 430,449 |        
|                                                                                    | Deferred compensation                                                                                                        |                                            |         | (1,048      | )       |              |         | (1,985  | )      
|                                                                                    | Accumulated
other comprehensive income (loss)                                                                                |                                            |         | 97          |         |              |         | (2,312  | )      
|                                                                                    | Retained earnings                                                                                                            |                                            |         | 8,229       |         |              |         | 735     |        
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              | Total stockholders equity                 |         |             | 445,664 |              |         |         | 426,935 | 
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        
|                                                                                    |                                                                                                                              | Total liabilities and stockholders equity |         | $           | 518,069 |              |         | $       | 500,984 | 
|                                                                                    |                                                                                                                              |                                            |         |             |         |              |         |        

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INTERNET SECURITY SYSTEMS, INC.




CONSOLIDATED STATEMENTS OF OPERATIONS


(Amounts in thousands, except per share amounts)
(Unaudited)


|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |        |        | 
|--------------------------------------------------- | -------------------------------------------------------------- | --------------------------------------- | ------ | ------------------ | ------ | ---------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                    |                                                                |                                         |        | Three months ended |        | Six months ended
|                                                    |                                                                |                                         |        | June 30,           |        | June 30,        
|                                                    |                                                                |                                         |        |                    |        |                 
|                                                    |                                                                |                                         |        | 2002               |        | 2001             |         | 2002   |        | 2001
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |     
|Revenues:                                           |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    | Product licenses and sales                                     |                                         | $      | 30,187             |        |                  | $       | 28,088 |        |      | $       | 60,400 |        |   | $       | 64,264 |       
|                                                    | Subscriptions                                                  |                                         |        | 22,788             |        |                  |         | 15,460 |        |      |         | 43,110 |        |   |         | 30,596 |       
|                                                    | Professional services                                          |                                         |        | 7,056              |        |                  |         | 8,162  |        |      |         | 14,898 |        |   |         | 18,005 |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    |                                                                |                                         | 60,031 |                    |        |                  | 51,710  |        |        |      | 118,408 |        |        |   | 112,865 |       
|Costs and expenses:                                 |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    | Cost of revenues:                                              |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |        |       
|                                                    |                                                                | Product licenses and sales              |        |                    | 1,344  |                  |         |        | 3,607  |      |         |        | 3,671  |   |         |        | 10,151 | 
|                                                    |                                                                | Subscriptions and professional services |        |                    | 13,362 |                  |         |        | 13,457 |      |         |        | 25,871 |   |         |        | 25,295 | 
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    |                                                                | Total cost of revenues                  |        | 14,706             |        |                  |         | 17,064 |        |      |         | 29,542 |        |   |         | 35,446 |       
|                                                    | Research and development                                       |                                         |        | 8,821              |        |                  |         | 8,940  |        |      |         | 17,428 |        |   |         | 17,255 |       
|                                                    | Sales and marketing                                            |                                         |        | 23,902             |        |                  |         | 23,913 |        |      |         | 46,589 |        |   |         | 45,547 |       
|                                                    | General and administrative                                     |                                         |        | 6,832              |        |                  |         | 5,085  |        |      |         | 12,276 |        |   |         | 9,596  |       
|                                                    | Charge for in-process research and development                 |                                         |        |                   |        |                  |         | 2,910  |        |      |         |       |        |   |         | 2,910  |       
|                                                    | Write-off of lease obligation                                  |                                         |        |                   |        |                  |         |       |        |      |         |       |        |   |         | 1,072  |       
|                                                    | Amortization of other intangibles and stock-based
compensation |                                         |        | 1,464              |        |                  |         | 1,146  |        |      |         | 2,960  |        |   |         | 1,314  |       
|                                                    | Amortization of goodwill                                       |                                         |        |                   |        |                  |         | 3,930  |        |      |         |       |        |   |         | 4,128  |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    |                                                                |                                         | 55,725 |                    |        |                  | 62,988  |        |        |      | 108,795 |        |        |   | 117,268 |       
|Operating income (loss)                             |                                                                |                                         | 4,306  |                    |        |                  | (11,278 | )      |        |      | 9,613   |        |        |   | (4,403  | )     
|Interest income, net                                |                                                                |                                         | 872    |                    |        |                  | 1,792   |        |        |      | 1,602   |        |        |   | 3,750   |       
|Minority interest                                   |                                                                |                                         | (68    | )                  |        |                  |        |        |        |      | (207    | )      |        |   |        |       
|Other income                                        |                                                                |                                         | 1,873  |                    |        |                  |        |        |        |      | 1,836   |        |        |   | 1,638   |       
|Foreign currency exchange loss                      |                                                                |                                         | (100   | )                  |        |                  | (31     | )      |        |      | (77     | )      |        |   | (282    | )     
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Income (loss) before income taxes                   |                                                                |                                         | 6,883  |                    |        |                  | (9,517  | )      |        |      | 12,767  |        |        |   | 703     |       
|Provision for (benefit from) income taxes           |                                                                |                                         | 2,758  |                    |        |                  | (3,907  | )      |        |      | 5,273   |        |        |   | (228    | )     
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Net income (loss)                                   |                                                                | $                                       | 4,125  |                    |        | $                | (5,610  | )      |        | $    | 7,494   |        |        | $ | 931     |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Basic net income (loss) per share of Common Stock   |                                                                | $                                       | 0.09   |                    |        | $                | (0.13   | )      |        | $    | 0.16    |        |        | $ | 0.02    |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Diluted net income (loss) per share of Common Stock |                                                                | $                                       | 0.08   |                    |        | $                | (0.13   | )      |        | $    | 0.15    |        |        | $ | 0.02    |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Weighted average shares:                            |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    | Basic                                                          |                                         |        | 48,340             |        |                  |         | 44,392 |        |      |         | 47,924 |        |   |         | 43,299 |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                                    | Diluted                                                        |                                         |        | 48,927             |        |                  |         | 44,392 |        |      |         | 48,773 |        |   |         | 44,922 |       
|                                                    |                                                                |                                         |        |                    |        |                  |         |        |        |      |         |        |        |   |         |       

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INTERNET SECURITY SYSTEMS, INC.




CONSOLIDATED STATEMENTS OF CASH FLOWS


(Amounts in thousands)
(Unaudited)


|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |   |        |         |  
|--------------------------------------------------------------------------------- | ------------------------------------------------------------------------ | -------------------------------------------------------------- | --------------------------------------------------- | - | ---------------- | ------ | ------- | - | ------ | ------- | -
|                                                                                  |                                                                          |                                                                |                                                     |   | Six months ended
|                                                                                  |                                                                          |                                                                |                                                     |   | June 30,        
|                                                                                  |                                                                          |                                                                |                                                     |   |                 
|                                                                                  |                                                                          |                                                                |                                                     |   | 2002             |        | 2001   
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |        
|OPERATING ACTIVITIES                                                              |                                                                          |                                                                |                                                     |   |                  |        |         |  
|Net income                                                                        |                                                                          | $                                                              | 7,494                                               |   |                  | $      | 931     |  
|Adjustments to reconcile net income to net cash
provided by operating activities: |                                                                          |                                                                |                                                     |   |                  |        |         |  
|                                                                                  |                                                                          | Depreciation                                                   |                                                     |   | 7,145            |        |         |   | 5,205  |        
|                                                                                  |                                                                          | Amortization of goodwill                                       |                                                     |   |                 |        |         |   | 4,128  |        
|                                                                                  |                                                                          | Amortization of other intangibles and stock-based compensation |                                                     |   | 2,960            |        |         |   | 1,314  |        
|                                                                                  |                                                                          | Accretion of discount on marketable securities                 |                                                     |   | 381              |        |         |   | 73     |        
|                                                                                  |                                                                          | Minority interest                                              |                                                     |   | 207              |        |         |   |       |        
|                                                                                  |                                                                          | Charge for in-process research and development                 |                                                     |   |                 |        |         |   | 2,910  |        
|                                                                                  |                                                                          | Other non-cash items                                           |                                                     |   |                 |        |         |   | 46     |        
|                                                                                  |                                                                          | Income tax benefit from exercise of stock options              |                                                     |   | 4,225            |        |         |   | 2,022  |        
|                                                                                  |                                                                          | Gain on sale of subsidiary stock                               |                                                     |   |                 |        |         |   | (1,638 | )      
|                                                                                  | Changes
in assets and liabilities, excluding the effect of acquisitions: |                                                                |                                                     |   |                  |        |         |   |       
|                                                                                  |                                                                          | Accounts receivable                                            |                                                     |   | (5,508           | )      |         |   | 5,127  |        
|                                                                                  |                                                                          | Inventory                                                      |                                                     |   | (388             | )      |         |   | 858    |        
|                                                                                  |                                                                          | Prepaid expenses and other assets                              |                                                     |   | (2,992           | )      |         |   | (4,881 | )      
|                                                                                  |                                                                          | Accounts payable and accrued expenses                          |                                                     |   | (2,523           | )      |         |   | (5,320 | )      
|                                                                                  |                                                                          | Deferred revenues                                              |                                                     |   | 1,800            |        |         |   | 4,217  |        
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  
|                                                                                  |                                                                          |                                                                | NET CASH PROVIDED BY OPERATING ACTIVITIES           |   |                  | 12,801 |         |   |        | 14,992  |  
|INVESTING ACTIVITIES                                                              |                                                                          |                                                                |                                                     |   |                  |        |         |  
|Acquisitions, net of cash received                                                |                                                                          |                                                                |                                                    |   |                  |        | 2,307   |  
|Net proceeds from maturity of marketable securities                               |                                                                          |                                                                | 64,396                                              |   |                  |        | 72,531  |  
|Purchases of marketable securities                                                |                                                                          |                                                                | (42,345                                             | ) |                  |        | (70,425 | )
|Purchases of property and equipment                                               |                                                                          |                                                                | (7,915                                              | ) |                  |        | (20,193 | )
|Net proceeds from sale of subsidiary stock                                        |                                                                          |                                                                |                                                    |   |                  |        | 1,766   |  
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  
|                                                                                  |                                                                          |                                                                | NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES |   |                  | 14,136 |         |   |        | (14,014 | )
|FINANCING ACTIVITIES                                                              |                                                                          |                                                                |                                                     |   |                  |        |         |  
|Proceeds from exercise of stock options                                           |                                                                          |                                                                | 2,756                                               |   |                  |        | 12,599  |  
|Proceeds from issuance of common stock                                            |                                                                          |                                                                | 1,142                                               |   |                  |        | 1,228   |  
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  
|                                                                                  |                                                                          |                                                                | NET CASH PROVIDED BY FINANCING ACTIVITIES           |   |                  | 3,898  |         |   |        | 13,827  |  
|Foreign currency impact on cash                                                   |                                                                          |                                                                | 2,409                                               |   |                  |        | (396    | )
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  
|Net increase in cash and cash equivalents                                         |                                                                          |                                                                | 33,244                                              |   |                  |        | 14,409  |  
|Cash and cash equivalents at beginning of period                                  |                                                                          |                                                                | 108,038                                             |   |                  |        | 66,210  |  
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  
|Cash and cash equivalents at end of period                                        |                                                                          | $                                                              | 141,282                                             |   |                  | $      | 80,619  |  
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  
|SUPPLEMENTAL CASH FLOW DISCLOSURE                                                 |                                                                          |                                                                |                                                     |   |                  |        |         |  
|Income taxes paid                                                                 |                                                                          | $                                                              | 2,502                                               |   |                  | $      |        |  
|                                                                                  |                                                                          |                                                                |                                                     |   |                  |        |         |  

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INTERNET SECURITY SYSTEMS, INC.




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.   Basis of presentation and significant accounting policies

The consolidated financial statements of Internet Security Systems, Inc.
(ISS) as of June 30, 2002 and for the three and six months ended June 30, 2002 and
2001 are unaudited and, in the opinion of management, contain all adjustments,
consisting of normal recurring items necessary for the fair presentation of the
financial position and results of operations for the interim periods. The
consolidated financial statements include the accounts of Internet Security
Systems, Inc. and its majority-owned subsidiaries. The consolidated balance
sheet at December 31, 2001 has been derived from the audited financial
statements at that date but does not include all the footnotes required by
accounting principles generally accepted in the United States for complete
financial statements.

These consolidated financial statements should be read in conjunction with
the Consolidated Financial Statements and Notes thereto included in our Annual
Report on Form 10-K for the year ended December 31, 2001. The results of
operations for the three and six months ended June 30, 2002 are not necessarily
indicative of the results to be expected for the entire year. All significant
intercompany accounts and transactions have been eliminated. Certain previously
reported amounts have been reclassified to conform to the current presentation
format.

The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the
United States requires management to
make estimates and assumptions that affect the amounts reported in the
financial statements and accompanying notes. Actual results could differ from
those estimates.

2.   Other income and expense

Other income reported
in the quarter ended June 30, 2002 consists of a
$1.9 million gain on the sale of an investment in an ISS distributor in Japan.
The shares of the publicly traded company were acquired when the distributor
was privately held and were subsequently sold on the open market. The gain is
substantially offset by expenses included in the general and administrative
category resulting from the consolidation of Tokyo-based operations from
several different locations to a new centralized headquarters in Tokyo. Costs
associated with this move included lease termination costs, including remaining
rent payments, write-off of leasehold improvements and moving costs.

Included in pretax income in the six months ended June 30, 2001, is a
non-recurring other income item of $1.6 million generated from the sale of
approximately 2% of the outstanding shares of our Asia-Pacific subsidiary in
March 2001. As part of the planning for an IPO in Japan of a minority interest
in our Asia-Pacific subsidiary that was completed in September 2001, options
were granted in the subsidiary as a means of key employee retention and
approximately 2% of the outstanding shares were sold to employees and key
partners. The price was established based on a valuation of the company by an
independent appraisal firm. The gain represents the difference between proceeds
received and the underlying basis in the stock.

In the six months ended June 30, 2001, the Company recorded a first
quarter $1.1 million write-off of the remaining lease obligation on our
previous Atlanta office space. This non-recurring expense originated in the
quarter as available subleased space in the area grew substantially as the
result of layoffs, closures and consolidations, diminishing the prospects of
subleasing our old space.

3. Goodwill and intangible
assets

The Company adopted Statement of Financial
Accounting Standards (SFAS) No. 142,
Goodwill and Other Intangible Assets on
January 1, 2002. As a result, goodwill is no longer
amortized, but is instead tested for impairment annually or
sooner if circumstances indicate that it may no longer be
recoverable. Upon adoption, the Company completed the
transitional goodwill impairment assessment required by
SFAS No. 142 and concluded that goodwill was not
impaired at January 1, 2002.

Goodwill and intangible assets are comprised of
the following (in thousands):

|                               |                        |                |  |                   |        |                |  |              |        |   |  |         |        |  |  |         |        |  
|------------------------------ | ---------------------- | -------------- |  | ----------------- | ------ | -------------- |  | ------------ | ------ | - |  | ------- | ------ |  |  | ------- | ------ | -
|                               |                        | June 30,
2002  |  | December 31, 2001
|                               |                        | Gross Carrying |  | Accumulated       |        | Gross Carrying |  | Accumulated 
|                               |                        | Amount         |  | Amortization      |        | Amount         |  | Amortization
|                               |                        |                |  |                   |        |                |  |             
|Unamortized intangible assets: |                        |                |  |                   |        |                |  |              |        |   |  |         |        |  |  |        
|                               | Goodwill               |                |  | 224,265           |        |                |  | (27,381      | )      |   |  | 224,441 |        |  |  | (27,381 | )     
|                               |                        |                |  |                   |        |                |  |              |        |   |  |         |        |  |  |        
|Amortized intangible assets:   |                        |                |  |                   |        |                |  |              |        |   |  |         |        |  |  |        
|                               | Core technology        |                |  | 3,853             |        |                |  | (1,797       | )      |   |  | 3,853   |        |  |  | (1,557  | )     
|                               | Developed technology   |                |  | 17,808            |        |                |  | (4,268       | )      |   |  | 17,808  |        |  |  | (2,487  | )     
|                               | Work force             |                |  | 215               |        |                |  | (134         | )      |   |  | 215     |        |  |  | (116    | )     
|                               | Customer relationships |                |  | 1,538             |        |                |  | (702         | )      |   |  | 2,490   |        |  |  | (484    | )     
|                               |                        |                |  |                   |        |                |  |              |        |   |  |         |        |  |  |        
|                               |                        | Total          |  |                   | 23,414 |                |  |              | (6,901 | ) |  |         | 24,366 |  |  |         | (4,644 | )
|                               |                        |                |  |                   |        |                |  |              |        |   |  |         |        |  |  |        

The Company amortizes intangible assets over
their estimated useful lives of eight years for core technology,
five years for developed technology, six years for work force
and three years for customer relationships.

Amortization expense of intangible assets (in
thousands):

|                       |       |                    |     |                  |  |      |       |       |  |  |       |       |  |  |       |       | 
|---------------------- | ----- | ------------------ | --- | ---------------- |  | ---- | ----- | ----- |  |  | ----- | ----- |  |  | ----- | ----- | 
|                       |       |                    |     |                 
|                       |       | Three months ended |     | Six months ended
|                       |       | June 30,           |     | June 30,        
|                       |       | 2002               |     | 2001             |  | 2002 |       | 2001 
|                       |       |                    |     |                  |  |      |       |      
|Goodwill               |       |                    |    |                  |  |      | 3,930 |       |  |  |      |       |  |  | 4,128 |      
|Core technology        |       |                    | 120 |                  |  |      | 120   |       |  |  | 241   |       |  |  | 241   |      
|Developed technology   |       |                    | 890 |                  |  |      | 323   |       |  |  | 1,781 |       |  |  | 361   |      
|Work force             |       |                    | 9   |                  |  |      | 9     |       |  |  | 18    |       |  |  | 18    |      
|Customer relationships |       |                    | 110 |                  |  |      | 95    |       |  |  | 218   |       |  |  | 95    |      
|                       |       |                    |     |                  |  |      |       |       |  |  |       |       |  |  |       |      
|                       | Total |                    |     | 1,129            |  |      |       | 4,477 |  |  |       | 2,258 |  |  |       | 4,843 | 
|                       |       |                    |     |                  |  |      |       |       |  |  |       |       |  |  |       |      

The estimated future amortization expense of
intangible assets as of June 30, 2002 is as follows (in
thousands):

|             |                             |        |  |        | 
|------------ | --------------------------- | ------ |  | ------ | 
|             |                             | Amount
|             |                             |       
|Fiscal year: |                             |        |  |       
|             | 2002 (remaining six months) |        |  | 2,258  | 
|             | 2003                        |        |  | 4,479  | 
|             | 2004                        |        |  | 4,100  | 
|             | 2005                        |        |  | 3,892  | 
|             | 2006                        |        |  | 1,784  | 
|             | 2007 and later              |        |  |       | 
|             |                             |        |  |       
|             |                             |        |  | 16,513 | 
|             |                             |        |  |       

The following table presents a reconciliation of
previously reported net income (loss) and net income (loss) per
share to the amounts adjusted for the exclusion of the
amortization of goodwill (in thousands):

|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |       | 
|------------------------------------------------ | ------------------------ | ------------------ | ----- | ---------------- |  | ---- | ------ | ----- |  | - | ----- | - |  | - | ----- | ----- | 
|                                                 |                          |                    |       |                 
|                                                 |                          | Three months ended |       | Six months ended
|                                                 |                          | June 30,           |       | June 30,        
|                                                 |                          | 2002               |       | 2001             |  | 2002 |        | 2001 
|                                                 |                          |                    |       |                  |  |      |        |      
|Net income (loss), reported                      |                          | $                  | 4,125 |                  |  | $    | (5,610 | )     |  | $ | 7,494 |   |  | $ | 931   |      
|                                                 | Amortization of goodwill |                    |       |                 |  |      |        | 3,930 |  |   |       |  |  |   |       | 4,128 | 
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|Net income (loss), as adjusted                   |                          |                    | 4,125 |                  |  |      | (1,680 | )     |  |   | 7,494 |   |  |   | 5,059 |      
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|Basic net income (loss) per share, as reported   |                          | $                  | 0.09  |                  |  | $    | (0.13  | )     |  | $ | 0.16  |   |  | $ | 0.02  |      
|Amortization of goodwill                         |                          |                    |      |                  |  |      | 0.09   |       |  |   |      |   |  |   | 0.10  |      
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|Basic net income (loss) per share, as adjusted   |                          | $                  | 0.09  |                  |  | $    | (0.04  | )     |  | $ | 0.16  |   |  | $ | 0.12  |      
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|Diluted net income (loss) per share, as reported |                          | $                  | 0.08  |                  |  | $    | (0.13  | )     |  | $ | 0.15  |   |  | $ | 0.02  |      
|                                                 | Amortization of goodwill |                    |       |                 |  |      |        | 0.09  |  |   |       |  |  |   |       | 0.09  | 
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      
|Diluted net income (loss) per share, as adjusted |                          | $                  | 0.08  |                  |  | $    | (0.04  | )     |  | $ | 0.15  |   |  | $ | 0.11  |      
|                                                 |                          |                    |       |                  |  |      |        |       |  |   |       |   |  |   |       |      

For the quarter ended June 30, 2001 options
aggregating 1,654,544 are not included in the above calculation
as they are antidilutive.

4.   Comprehensive
income (loss)

The components of comprehensive income (loss), net of tax, are as follows (in
thousands):

|                                            |  |                    |       |                  |  |      |        |      |  |   |       |  |  |   |      |  
|------------------------------------------- |  | ------------------ | ----- | ---------------- |  | ---- | ------ | ---- |  | - | ----- |  |  | - | ---- | -
|                                            |  | Three months ended |       | Six months ended
|                                            |  | June 30,           |       | June 30,        
|                                            |  |                    |       |                 
|                                            |  | 2002               |       | 2001             |  | 2002 |        | 2001
|                                            |  |                    |       |                  |  |      |        |     
|Net income (loss)                           |  | $                  | 4,125 |                  |  | $    | (5,610 | )    |  | $ | 7,494 |  |  | $ | 931  |  
|Change in cumulative translation adjustment |  |                    | 3,094 |                  |  |      | 553    |      |  |   | 2,409 |  |  |   | (396 | )
|                                            |  |                    |       |                  |  |      |        |      |  |   |       |  |  |   |      |  
|Comprehensive
income (loss)                 |  | $                  | 7,219 |                  |  | $    | (5,057 | )    |  | $ | 9,904 |  |  | $ | 535  |  
|                                            |  |                    |       |                  |  |      |        |      |  |   |       |  |  |   |      |  

5.   Income (loss) per share

The computation of net income (loss) per share is as follows (amounts in
thousands, except per share amounts):

|                                     |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |        | 
|------------------------------------ | --------------------------------------------------------------------------- | - | ------------------ | ------ | ---------------- | - | ----- | ------ | ---- | - | ---- | ------ |  | - | ---- | ------ | 
|                                     |                                                                             |   | Three months ended |        | Six months ended
|                                     |                                                                             |   | June 30,           |        | June 30,        
|                                     |                                                                             |   |                    |        |                 
|                                     |                                                                             |   | 2002               |        | 2001             |   | 2002  |        | 2001
|                                     |                                                                             |   |                    |        |                  |   |       |        |     
|Basic net income (loss) per share:   |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       
|                                     | Net income (loss)                                                           |   | $                  | 4,125  |                  |   | $     | (5,610 | )    |   | $    | 7,494  |  |   | $    | 931    | 
|                                     | Weighted average number of common shares
outstanding during the period      |   |                    | 48,340 |                  |   |       | 44,392 |      |   |      | 47,924 |  |   |      | 43,299 | 
|                                     |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       
|Basic net income (loss) per share    |                                                                             | $ | 0.09               |        |                  | $ | (0.13 | )      |      | $ | 0.16 |        |  | $ | 0.02 |       
|                                     |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       
|Diluted net income (loss) per share: |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       
|                                     | Net income (loss)                                                           |   | $                  | 4,125  |                  |   | $     | (5,610 | )    |   | $    | 7,494  |  |   | $    | 931    | 
|                                     | Weighted average number of common shares
outstanding during the period      |   |                    | 48,340 |                  |   |       | 44,392 |      |   |      | 47,924 |  |   |      | 43,299 | 
|                                     | Dilutive stock options                                                      |   |                    | 587    |                  |   |       |       |      |   |      | 849    |  |   |      | 1,623  | 
|                                     |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       
|                                     | Total shares for purpose of calculating
diluted net income (loss) per share |   |                    | 48,927 |                  |   |       | 44,392 |      |   |      | 48,773 |  |   |      | 44,922 | 
|                                     |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       
|Diluted net income (loss) per share  |                                                                             | $ | 0.08               |        |                  | $ | (0.13 | )      |      | $ | 0.15 |        |  | $ | 0.02 |       
|                                     |                                                                             |   |                    |        |                  |   |       |        |      |   |      |        |  |   |      |       

Options aggregating
1,654,544 for the three months ended June 30, 2001 are not included
in the above calculation as they are antidilutive.

6



---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6.   Segment and geographic information

ISS conducts business in one operating segment, providing information
security management solutions. The Company does, however, prepare information
for internal use on a geographic basis (e.g., Americas, EMEA (Europe,
Middle East and Africa) and Asia/Pacific). This information consists of the
operating results of each geographic segment. The segment operating costs
reported internally generally consist of direct sales expenses, an executive
team and infrastructure to support its employee and customer and partner base,
and supporting billing and financial systems. Unallocated corporate expenses
include research and development, general and administrative costs that support
the global organization and amortization of intangibles, stock based
compensation and goodwill.

There are no intersegment
sales. Our chief executive officer and chief financial officer evaluate
performance based on operating profit or loss from operations by segment.
Assets and liabilities are not discretely allocated or reviewed by segment.

The following table presents ISSs revenues, operating expenses and
operating income (loss) by geographic segment (amounts in thousands):

|                                  |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |       |        |        |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |        |        | 
|--------------------------------- | --------------------------------------- | -------------------------- | ------ | -------------------------------- | ------ | -------------------------------- | ----- | ------------ | ----- | ----------- | ----- | ----- | ----- | -------- | ------- | ---- | - | ------------ | ------ | ----------- | ------ | ----- | ------ | ------ | ------ | - | ----- | ----- | ----- | - | ----- | ----- | ----- | - | ------- | - | - | - | ------- | ------ | ------ | 
|                                  |                                         |                            |        | Three months ended June 30, 2002 |        | Three months ended June 30, 2001
|                                  |                                         |                            |        |                                  |        |                                 
|                                  |                                         |                            |        | Americas                         |        | EMEA                             |       | Asia/Pacific |       | Unallocated |       | Total |       | Americas |         | EMEA |   | Asia/Pacific |        | Unallocated |        | Total
|                                  |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |      
|Revenues from
external customers: |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |       |        |        |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|                                  |                                         | Product licenses
and sales |        | $                                | 20,272 |                                  |       | $            | 4,534 |             |       | $     | 5,381 |          |         | $    |  |              |        | $           | 30,187 |       |        | $      | 18,079 |   |       | $     | 4,654 |   |       | $     | 5,355 |   |         | $ |  |   |         | $      | 28,088 | 
|                                  |                                         | Subscriptions              |        |                                  | 17,642 |                                  |       |              | 3,095 |             |       |       | 2,051 |          |         |      |  |              |        |             | 22,788 |       |        |        | 12,962 |   |       |       | 1,438 |   |       |       | 1,060 |   |         |   |  |   |         |        | 15,460 | 
|                                  |                                         | Professional
services      |        |                                  | 4,750  |                                  |       |              | 1,464 |             |       |       | 842   |          |         |      |  |              |        |             | 7,056  |       |        |        | 5,891  |   |       |       | 1,816 |   |       |       | 455   |   |         |   |  |   |         |        | 8,162  | 
|                                  |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |       |        |        |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|Total revenue                     |                                         |                            | 42,664 |                                  |        |                                  | 9,093 |              |       |             | 8,274 |       |       |          |        |      |   |              | 60,031 |             |        |       | 36,932 |        |        |   | 7,908 |       |       |   | 6,870 |       |       |   |        |   |   |   | 51,710  |       
|Cost of revenues:                 |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |       |        |        |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|                                  | Product licenses and
sales              |                            |        | 1,344                            |        |                                  |       |             |       |             |       |      |       |          |         |     |   |              |        | 1,344       |        |       |        | 3,439  |        |   |       | 168   |       |   |       |      |       |   |         |  |   |   |         | 3,607  |       
|                                  | Subscriptions and
professional
services |                            |        | 9,067                            |        |                                  |       | 2,185        |       |             |       | 2,110 |       |          |         |     |   |              |        | 13,362      |        |       |        | 10,278 |        |   |       | 2,003 |       |   |       | 1,176 |       |   |         |  |   |   |         | 13,457 |       
|                                  |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |       |        |        |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|Total cost of revenues            |                                         |                            | 10,411 |                                  |        |                                  | 2,185 |              |       |             | 2,110 |       |       |          |        |      |   |              | 14,706 |             |        |       | 13,717 |        |        |   | 2,171 |       |       |   | 1,176 |       |       |   |        |   |   |   | 17,064  |       
|Operating expenses                |                                         |                            | 16,781 |                                  |        |                                  | 4,734 |              |       |             | 2,387 |       |       |          | 17,117  |      |   |              | 41,019 |             |        |       | 16,997 |        |        |   | 5,627 |       |       |   | 2,487 |       |       |   | 20,813  |   |   |   | 45,924  |       
|                                  |                                         |                            |        |                                  |        |                                  |       |              |       |             |       |       |       |          |         |      |   |              |        |             |        |       |        |        |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|Total expenses                    |                                         |                            | 27,192 |                                  |        |                                  | 6,919 |              |       |             | 4,497 |       |       |          | 17,117  |      |   |              | 55,725 |             |        |       | 30,714 |        |        |   | 7,798 |       |       |   | 3,663 |       |       |   | 20,813  |   |   |   | 62,988  |       
|Segment operating
income (loss)   |                                         | $                          | 15,472 |                                  |        | $                                | 2,174 |              |       | $           | 3,777 |       |       | $        | (17,117 | )    |   | $            | 4,306  |             |        | $     | 6,218  |        |        | $ | 110   |       |       | $ | 3,207 |       |       | $ | (20,813 | ) |   | $ | (11,278 | )     

|                                  |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |       |        |        |        |   |        |       |       |   |        |       |        |   |         |   |   |   |         |        |        | 
|--------------------------------- | --------------------------------------- | -------------------------- | ------ | ------------------------------ | ------ | ------------------------------ | ------ | ------------ | ----- | ----------- | ------ | ----- | ------ | -------- | ------- | ---- | - | ------------ | ------- | ----------- | ------ | ----- | ------ | ------ | ------ | - | ------ | ----- | ----- | - | ------ | ----- | ------ | - | ------- | - | - | - | ------- | ------ | ------ | 
|                                  |                                         |                            |        | Six months ended June 30, 2002 |        | Six months ended June 30, 2001
|                                  |                                         |                            |        |                                |        |                               
|                                  |                                         |                            |        | Americas                       |        | EMEA                           |        | Asia/Pacific |       | Unallocated |        | Total |        | Americas |         | EMEA |   | Asia/Pacific |         | Unallocated |        | Total
|                                  |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |      
|Revenues from external customers: |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |       |        |        |        |   |        |       |       |   |        |       |        |   |         |   |   |   |         |       
|                                  |                                         | Product licenses and sales |        | $                              | 41,122 |                                |        | $            | 8,864 |             |        | $     | 10,414 |          |         | $    |  |              |         | $           | 60,400 |       |        | $      | 44,513 |   |        | $     | 8,994 |   |        | $     | 10,757 |   |         | $ |  |   |         | $      | 64,264 | 
|                                  |                                         | Subscriptions              |        |                                | 33,424 |                                |        |              | 5,682 |             |        |       | 4,004  |          |         |      |  |              |         |             | 43,110 |       |        |        | 24,318 |   |        |       | 4,139 |   |        |       | 2,139  |   |         |   |  |   |         |        | 30,596 | 
|                                  |                                         | Professional services      |        |                                | 9,860  |                                |        |              | 2,801 |             |        |       | 2,237  |          |         |      |  |              |         |             | 14,898 |       |        |        | 12,805 |   |        |       | 3,688 |   |        |       | 1,512  |   |         |   |  |   |         |        | 18,005 | 
|                                  |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |       |        |        |        |   |        |       |       |   |        |       |        |   |         |   |   |   |         |       
|Total revenue                     |                                         |                            | 84,406 |                                |        |                                | 17,347 |              |       |             | 16,655 |       |        |          |        |      |   |              | 118,408 |             |        |       | 81,636 |        |        |   | 16,821 |       |       |   | 14,408 |       |        |   |        |   |   |   | 112,865 |       
|Cost of revenues:                 |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |       |        |        |        |   |        |       |       |   |        |       |        |   |         |   |   |   |         |       
|                                  | Product licenses and sales              |                            |        | 3,629                          |        |                                |        |             |       |             |        | 42    |        |          |         |     |   |              |         | 3,671       |        |       |        | 9,889  |        |   |        | 252   |       |   |        | 10    |        |   |         |  |   |   |         | 10,151 |       
|                                  | Subscriptions and professional services |                            |        | 17,629                         |        |                                |        | 4,361        |       |             |        | 3,881 |        |          |         |     |   |              |         | 25,871      |        |       |        | 19,330 |        |   |        | 3,618 |       |   |        | 2,347 |        |   |         |  |   |   |         | 25,295 |       
|                                  |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |       |        |        |        |   |        |       |       |   |        |       |        |   |         |   |   |   |         |       
|Total cost of revenues            |                                         |                            | 21,258 |                                |        |                                | 4,361  |              |       |             | 3,923  |       |        |          |        |      |   |              | 29,542  |             |        |       | 29,219 |        |        |   | 3,870  |       |       |   | 2,357  |       |        |   |        |   |   |   | 35,446  |       
|Operating expenses                |                                         |                            | 33,206 |                                |        |                                | 9,162  |              |       |             | 4,221  |       |        |          | 32,664  |      |   |              | 79,253  |             |        |       | 30,444 |        |        |   | 10,287 |       |       |   | 4,816  |       |        |   | 36,275  |   |   |   | 81,822  |       
|                                  |                                         |                            |        |                                |        |                                |        |              |       |             |        |       |        |          |         |      |   |              |         |             |        |       |        |        |        |   |        |       |       |   |        |       |        |   |         |   |   |   |         |       
|Total expenses                    |                                         |                            | 54,464 |                                |        |                                | 13,523 |              |       |             | 8,144  |       |        |          | 32,664  |      |   |              | 108,795 |             |        |       | 59,663 |        |        |   | 14,157 |       |       |   | 7,173  |       |        |   | 36,275  |   |   |   | 117,268 |       
|Segment operating income (loss)   |                                         | $                          | 29,942 |                                |        | $                              | 3,824  |              |       | $           | 8,511  |       |        | $        | (32,664 | )    |   | $            | 9,613   |             |        | $     | 21,973 |        |        | $ | 2,664  |       |       | $ | 7,235  |       |        | $ | (36,275 | ) |   | $ | (4,403  | )     

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INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7.   Recent accounting pronouncements

In July 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 142, (SFAS 142), Accounting for Goodwill
and Other Intangibles. Under SFAS 142, goodwill and indefinite lived
intangible assets are no longer amortized, but are reviewed annually (or more
frequently if impairment indicators arise) for impairment. Separable intangible
assets that are not deemed to have an indefinite life will continue to be
amortized over their useful lives. Companies were required to immediately adopt
the amortization provisions of SFAS 142 as it relates to goodwill and
intangible assets acquired after June 30, 2001. With respect to goodwill and
intangible assets acquired prior to July 1, 2001, companies were required to
adopt SFAS 142 in their fiscal year beginning after December 15, 2001. The
Company adopted SFAS 142 effective January 1, 2002. Substantially all of the
Companys goodwill balance of $196.9 million as of June 30, 2002, was recorded
in June of 2001, in conjunction with the acquisition of Network ICE. In doing
so, the Company determined that goodwill is not impaired, therefore, there was
no transitional impairment charge to be recorded. The impact of the adoption
as it relates to goodwill, which exists currently, is to eliminate amortization
of goodwill expense beginning with the year ending December 31, 2002. In 2001,
amortization of goodwill totaled $26.5 million.

On October 3,
2001, the FASB issued the Statement of Financial Accounting Standards
No. 144 Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS 144). SFAS 144
addresses financial accounting and reporting for the disposal of
long-lived assets. SFAS 144, becomes effective for financial
statements issued for fiscal years beginning after December 15,
2001, and interim periods within those fiscal years. The Company
adopted SFAS on January 1, 2002. The adoption did not have a
material impact on the Company's consolidated financial position,
consolidated results of operations or consolidated cash flows.

8.   Contingencies

Beginning on September 28, 2001, the Company and certain of its officers
and directors were named as defendants in several lawsuits alleging violations
of the federal securities laws, including Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and Rule 10b-5 thereunder. As of
March 27, 2002, six such actions have been filed in the United States District
Court for the Northern District of Georgia. The complaints, which are
substantially similar in nature, purport to be brought on behalf of a class of
investors who purchased the Companys stock during the period from April 5,
2001 through August 14, 2001 (the Class Period). The complaints generally
allege that the Company and the individual defendants violated the anti-fraud
provisions of the federal securities laws and caused the Companys stock to
trade at artificially high prices by making misrepresentations relating to the
Companys financial condition and prospects during the Class Period. The
complaints seek damages in an unspecified amount. All six actions
have been consolidated into a single case and the court has appointed
lead plaintiffs and lead plaintiff's counsel. The company expects
that the plaintiffs will file a consolidated, amended complaint. No answer or other
responsive papers are yet due from the defendants. The Company believes that it
has meritorious defenses and intends to defend the actions vigorously.

9.   Subsequent events

On July 11, 2002, the Board of Directors of the Company authorized a plan
to repurchase up to $50 million of the Companys stock over the next twelve
months. Subject to price and market conditions, purchases may be made from
time to time in the open market, block trades or private transactions using the
Companys available cash. The repurchase will be made using existing cash and
future cash flows from operations.

Also on July 11, 2002, the
Board of Directors adopted a shareholder rights
plan and authorized and declared a dividend of one preferred share
purchase right (a Right) for each outstanding share of
common stock, par value $.001 per share, of the Company. The dividend
was paid on July 29, 2002 to the stockholders of record on that
date. Stock issued subsequent to July 29, 2002 will be issued
with an attached Right. Each Right will initially represent the
rights, under certain circumstances, to purchase one one-thousandth
of a share of Series A Junior Participating Preferred Stock (the
Junior Preferred Stock) at a purchase price of $80 per
one one-thousandth of a share. If a person or group acquires
beneficial ownership of 20% or more of the then outstanding shares of
the Company's common stock (an Acquiring Person''), the holder
of a Right, upon exercise of the Right, will thereafter have the
right to receive, in lieu of shares of Junior Preferred Stock, shares
of the Company's common stock (or, in certain circumstances, cash,
property or other securities of the Company) having a value equal to
twice the purchase price of the Right.

The Rights expire on
July 11, 2012. Generally, the Board of Directors may redeem the
Rights at a price of $.001 per Right (subject to adjustment) at any
time prior to the earlier of (i) the close of business on the
tenth business day following the Shares Acquisition Date (as defined
in the rights plan) or (ii) the expiration date of the Rights.
Prior to any person or group becoming an Acquiring Person, the
Company may amend the Rights Agreement at any time.

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INTERNET SECURITY SYSTEMS, INC.




MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS


The following discussion should be read in conjunction with the Consolidated
Financial Statements and related Notes thereto included elsewhere in this
Quarterly Report on Form 10-Q. Except for the historical financial information,
the matters discussed in this Quarterly Report on Form 10-Q may be considered
forward-looking statements. Such statements include declarations regarding
our intent, belief or current expectations. Such forward-looking statements are
not guarantees of future performance and involve a number of risks and
uncertainties. Actual results may differ materially from those indicated by
such forward-looking statements. Among the important factors that could cause
actual results to differ materially from those indicated by such
forward-looking statements are the risk factors in this Quarterly Report on
Form 10-Q, as well as the risk factors identified in the Annual Report on Form
10-K for the year ended December 31, 2001 as filed with the Securities and
Exchange Commission and available at their Web site at www.sec.gov.

OVERVIEW

We are a global leader in information protection solutions dedicated to
protecting online assets. Our proactive line of defense protects networks,
servers and desktops against an ever-changing spectrum of threats, with a
comprehensive line of products and services designed specifically for the
particular needs of enterprise, smaller enterprise, consumer and service
provider markets. These threat protection solutions go beyond basic access
control to deliver multiple layers of defense that detect, prevent and respond
to threats prior to those threats causing damage to our customers business
operations.

We provide a wide range of proactive protection that spans networks,
servers and individual desktops, built around the need for comprehensive,
cost-effective detection, prevention and response arising from attacks, misuse
and security policy violations, all while ensuring the confidentiality,
privacy, integrity and availability of proprietary information.

Our family of products is a critical element of an active Internet and
networking security program within todays world of global connectivity,
enabling organizations to proactively monitor, detect and respond to risks to
enterprise information. Our line of products is designed specifically for the
particular needs of enterprise, smaller enterprise, consumer and service
provider markets.

Our managed services offerings currently provide remote management of the
industrys best-of-breed security technology including security assessment and
intrusion detection systems, firewalls, VPNs, anti-virus and URL filtering
software. We focus on serving as the trusted security provider to our customers
by maintaining within our existing products the latest counter-measures to
security risks, creating new innovative products based on our customers needs
and providing professional and managed services.

Many factors affect financial performance, and past performance is no
assurance of similar future performance. We expect, in the long-term, to
continue to expand our domestic and international sales and marketing
operations; increase our investment in product development including our
proprietary threat and vulnerability database and managed services
capabilities; seek acquisition candidates and alliances with partners and
alliances with partners with products, technologies or services capabilities
complimentary to our solutions; and improve our internal operating and
financial infrastructure in support of our strategic goals and objectives. At
the same time, we will adjust our organization size in light of current
economic conditions and maintain emphasis on controlling discretionary spending
and capital expenditures. While we believe in the long-term success of our
business solutions, our prospects must be considered in light of the recent
experience, risks and difficulties that are frequently encountered by companies
in new and rapidly evolving markets. See Risk Factors.

Critical accounting policies

The consolidated financial statements were prepared in conformity with
accounting principles generally accepted in the United States. As such,
management is required to make certain estimates, judgments and assumptions
it believes are reasonable based upon the information available. These
estimates and assumptions affect the reported amounts of assets and liabilities
at the date of the financial statements and the reported amounts of revenues
and expenses during the periods presented. The significant accounting policies
which management believes are the most critical to aid in fully understanding
and evaluating our reported financial results include the following:

Revenue recognition

Revenue is recognized under Statement of Position (SOP) 97-2 as modified
by SOP 98-9, when the following criteria have been met:

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS



| |  |  | persuasive evidence of an arrangement exists;        
| | - |  | -----------------------------------------------------
|
| |  |  | delivery has occurred or services have been rendered;
|
| |  |  | price is fixed and determinable; and                 
|
| |  |  | collection is probable.                              

We recognize
perpetual license revenues from ISS-developed products upon
(i) delivery of software or, if the customer has evaluation software, delivery
of the software key and (ii) issuance of the related license, assuming that no
significant vendor obligations or customer acceptance rights exist. Where
payment terms are extended over periods greater than 12 months, revenue is
recognized as such amounts become due. Product sales consist of (i)
appliances sold in conjunction with ISS licensed software and (ii) software
developed by third-party partners, combined in some instances with associated
hardware appliances and partner maintenance services. These sales are
recognized upon shipment to the customer.

License sales of enterprise and small enterprise products are generated
both through a direct sales force and through partners. License sales of small
office/home office and consumer products are made through a distributor to
retail establishments and are sold directly to customers via the Internet.
License revenue for sales made through resellers and distributors are
recognized only when the product is delivered to the end user.

Annual renewable maintenance is a separate component of each perpetual
license agreement for ISS products with revenue recognized ratably over the
maintenance term. Subscription revenues include maintenance, term licenses, and
managed service arrangements. Term licenses allow customers to use our products
and receive maintenance coverage for a specified period, generally 12 months.
We recognize revenues from these term agreements ratably over the subscription
term. Security monitoring services of information assets and systems are part
of managed services and are recognized as such services are provided.

Professional services revenues include fee-based service engagements and
training. Service engagements, typically billed on a time-and-materials basis,
primarily focus on security assessments of customer networks and the
development of customers security policies. We recognize such professional
services revenues as the related services are rendered.

Multiple element arrangements can include any combination of hardware,
software or services. When some elements are delivered prior to others in an
arrangement, revenue is deferred until the delivery of the last element unless
there is all of the following:



| |  |  | vendor specific objective evidence (VSOE) of fair value of the
undelivered elements;         
| | - |  | ---------------------------------------------------------------------------------------------
|
| |  |  | the functionality of the delivered elements is not dependent on the
undelivered elements; and
|
| |  |  | delivery of the delivered elements represents the culmination of the
earnings process.       

Our historical rate of return for our software products is negligible. We
offer demonstration software available via download from our website that
allows potential customers to see the functionality of the products on their
own networks. We did not have any transactions in the first half of
either 2002 or
2001 involving reciprocal arrangements where goods or services were purchased
from an organization at the same time that we licensed software or provided
services to that organization.

Allowance for doubtful accounts

Our sales are global, including companies located in the United States, Europe,
Latin America and the Asia/Pacific regions. We perform periodic credit
evaluations of our customers financial condition and do not require
collateral. Credit risk with respect to trade accounts receivable are limited
due to the large number of entities that comprise the Companys customer base.
We provide for estimated credit losses as such losses become probable and such
losses have been within managements expectations. We evaluate specific
accounts when we become aware of a situation where a customer may not be able
to meet its financial obligations due to a deterioration of its financial
viability, credit ratings or bankruptcy. The allowance for doubtful accounts
is established based on the best facts available to us and reevaluated and
adjusted as additional information is received.

Our provisions for bad debt during the three months ended June 30, 2002 and for
the six months ended June 30, 2002 amounted to $200,000 and $665,000,
respectively. At December 31, 2001, our allowance for doubtful accounts included
approximately $400,000

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

that had been reserved specifically for two customers, both of which were
successfully collected in 2002, and the allowance was decreased accordingly.
During the first half of 2002, in response to the difficult current economic
conditions, we wrote off approximately $340,000 of receivables that were deemed
uncollectible due to the deteriorating condition of certain customers. Our
June 30, 2002 allowance for bad debts totals 4.4% of the $55.8 million of
trade receivables.

While actual credit losses have historically been within managements expectations and
the provisions established, we cannot guarantee that we will continue to
experience the same credit loss rates we have in the past. If the financial
condition of our customers were to deteriorate, resulting in an impairment of
their ability to make payments, additional allowances may be required.

Impairment of goodwill

We currently have a significant intangible asset related to goodwill of
$197 million, with $195 million related to our June 2001 acquisition of Network
ICE Corporation. The determination of whether or not this asset is impaired
involves significant judgments based upon short and long-term projections of
future performance. We have concluded that this amount is realizable based
both on forecasted discounted cash flows through 2006 and on our stock market
valuation. The forecasted discounted cash flows include positive cash flow for
each year through 2006 and a minimum terminal value of approximately $289
million. Neither method indicated that our goodwill had been impaired and as a
result, we did not record any impairment losses related to goodwill during the
six months ended June 30, 2002 and 2001.

Due to uncertain market conditions and potential changes in our strategy
and products, it is possible that forecasts used to support our intangible
assets may change in the future which could result in significant non-cash
charges that would adversely affect our results of operations and financial
condition.

Results of operations

The following table sets forth certain consolidated historical operating
information, as a percentage of total revenues, for the periods indicated:

|                                                               |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |     |  
|-------------------------------------------------------------- | ------------------------ |  | ------------------ | --- | ---------------- |  | ---- | --- | ---- |  | -- | --- | - |  | -- | --- | -
|                                                               |                          |  | Three months ended |     | Six months ended
|                                                               |                          |  | June 30,           |     | June 30,        
|                                                               |                          |  |                    |     |                 
|                                                               |                          |  | 2002               |     | 2001             |  | 2002 |     | 2001
|                                                               |                          |  |                    |     |                  |  |      |     |     
|Product
licenses and sales                                     |                          |  | 50                 | %   |                  |  | 54   | %   |      |  | 51 | %   |   |  | 57 | %  
|Subscriptions                                                  |                          |  | 38                 | %   |                  |  | 30   | %   |      |  | 36 | %   |   |  | 27 | %  
|Professional services                                          |                          |  | 12                 | %   |                  |  | 16   | %   |      |  | 13 | %   |   |  | 16 | %  
|                                                               |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|                                                               | Total revenues           |  |                    | 100 | %                |  |      | 100 | %    |  |    | 100 | % |  |    | 100 | %
|                                                               |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|Cost of product revenues                                       |                          |  | 2                  | %   |                  |  | 7    | %   |      |  | 3  | %   |   |  | 9  | %  
|Cost of subscription and
professional service revenues         |                          |  | 22                 | %   |                  |  | 26   | %   |      |  | 22 | %   |   |  | 22 | %  
|Research and development                                       |                          |  | 15                 | %   |                  |  | 17   | %   |      |  | 15 | %   |   |  | 15 | %  
|Sales and marketing                                            |                          |  | 41                 | %   |                  |  | 46   | %   |      |  | 40 | %   |   |  | 40 | %  
|General and administrative                                     |                          |  | 11                 | %   |                  |  | 10   | %   |      |  | 10 | %   |   |  | 9  | %  
|Write-off of lease obligation                                  |                          |  |                   |     |                  |  |     |     |      |  |   |     |   |  | 1  | %  
|Charge for in-process
research and development                 |                          |  |                    |     |                  |  | 6    | %   |      |  |    |     |   |  | 3  | %  
|Amortization of goodwill                                       |                          |  |                   |     |                  |  | 8    | %   |      |  |   |     |   |  | 4  | %  
|Amortization of other
intangibles and
stock-based compensation |                          |  | 2                  | %   |                  |  | 2    | %   |      |  | 2  | %   |   |  | 1  | %  
|                                                               |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|                                                               | Total costs and expenses |  |                    | 93  | %                |  |      | 122 | %    |  |    | 92  | % |  |    | 104 | %
|                                                               |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|Operating income (loss)                                        |                          |  | 7                  | %   |                  |  | (22  | )%  |      |  | 8  | %   |   |  | (4 | )% 
|                                                               |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    

Revenues

Product licenses and sales

Product licenses and sales, including perpetual licenses and sales of
partner software and hardware appliances, continued to be the primary source of
revenue generation at 50% of total revenues for the three-month period ended
June 30, 2002 and 54% for the

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

corresponding period in 2001. Product licenses and sales represented 51%
of total revenues for the six-month period ended June 30, 2002, as compared to
57% for the same period in 2001. The decrease in product licenses and sales as
a percentage of total revenues is due to the decrease in the sales of
third-party products.

We have de-emphasized sales of third-party products in order to focus on
our own ISS solutions. As such, third-party product revenues decreased from 7%
of total revenue in the quarter ended June 30, 2001 to 2% in the corresponding
period of 2002, with a similar decrease on a year-to-date basis. Additionally,
in 2001, we modified our agreement with Nokia, a maker of appliances that work
in conjunction with ISS RealSecure software and certain Checkpoint software. We
previously purchased and resold these Nokia appliances with ISS RealSecure
software, but now the sale of the Nokia appliances occurs primarily through
Nokia resellers, with the sale of ISS RealSecure software directly by us or
through our resellers to our customers. This change lowered our sales because
the Nokia appliances component of sales is now occurring through Nokia
resellers. Although we have de-emphasized sales of third-party products, we
continue sales of third-party products as part of our managed security services
offerings.

License sales of enterprise and small enterprise products are generated
both through a direct sales force and through various partners, including
system integrators, value-added resellers and distributors. When our partners
generate sales, revenues are recognized when the end user sale has occurred,
which is identified through electronic delivery of a software key that is
necessary to operate the product.

License sales of small office/home office and consumer products are made
through distributors to retail establishments and are sold directly to
customers via the Internet. License revenue for sales made through our
distributors is recognized only when the product is sold to the end user.

Our product line advanced again in the second quarter of 2002, with
enhancements to our desktop, server and network protection solutions. We
released RealSecure Desktop Protector 3.5, which added the ability to block
outbound network traffic as well as new protection from malicious application
execution. We introduced broader platform support for our host products to
include several versions of Linux. We shipped a new version of our RealSecure
Network Sensor 7.0 with full support for high traffic gigabit networks, as well
as advanced detection algorithms, developed by integrating technology from our
2001 acquisition of NetworkICE with our existing technology. Our security
management application was updated as well, with a new SiteProtector release in
the quarter. SiteProtector remains the industrys only management application
to fully control host and network-based agents, as well as vulnerability
products to centralize data and to provide fast, guided analysis of security
data.

Subscriptions

Subscription revenues consist of maintenance, term licenses of product
usage and security-monitoring fees for managed services offerings.
Subscriptions revenue represented 38% of total revenues in the three months
ended June 30, 2002 increasing from 30% of total revenues in the three months
ended June 30, 2001. Maintenance continues to represent the largest portion of
our subscription revenue, accounting for 26% of total revenues in the three months ended
June 30, 2002 and 20% of total revenues in the comparable period of 2001. We
continue to increase our software client base that generates maintenance
revenues, through a combination of maintenance contracts associated with new
product licenses and a high renewal rate of existing contracts.

Our monitoring fees grew more than 22% in the second quarter of 2002, and
represented 7% of total revenues, a one percentage point increase over the
corresponding period of 2001. We continue to focus on our intrusion protection
offerings, the area of strongest demand.

On a year-to-date basis, subscriptions revenue represented 36% of total
revenues in the six months ended June 30, 2002, as compared to 27% in the six
months ended June 30, 2001. The year-to-date increase is primarily the result
of increased maintenance. Security-monitoring fees did not increase
significantly in the first half of 2002 compared with 2001 because we decreased non-core services during 2001.
Specifically, we eliminated a security
offering combined with internet service provider services in the fourth quarter
of 2001, and eliminated contracts where the partner contracted for
capacity, but did not achieve the underlying end-user contracts. We believe
that we now have a higher component of business that we perceive as providing
long-term value-added services to our customers.

Professional services

Professional services revenue represented 12% of total revenues in the
three months ended June 30, 2002, decreasing from 16% in the corresponding
period of 2001. For the six months ended June 30, 2002, professional services
revenue was 13% of revenue, which

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

was a decrease from 16% in the corresponding period of 2001. During 2002,
professional services as a percentage of total revenues decreased due to
continued customer reluctance to spend discretionary dollars on professional
services. Further contributing to this decline was a narrowing of our
consulting offerings to focus on high-value offerings that utilize our X-Force
expertise, and choosing to use partners to provide deployment and other
offerings where appropriate. We also decreased the number of training classes
related to third-party products and increased our emphasis on courses related
to ISS solutions.

Geographic regions

Geographically, we derived the majority of our revenues from sales to
customers within the Americas region; however, international operations
continued to be a significant contributor to revenues. Revenues by region
represented the following percentages of total revenues for the periods
indicated:

|                 |  |                    |    |                  |  |      |    |      |  |  |    |   |  |  |    |  
|---------------- |  | ------------------ | -- | ---------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                 |  | Three months ended |    | Six months ended
|                 |  | June 30,           |    | June 30,        
|                 |  |                    |    |                 
|                 |  | 2002               |    | 2001             |  | 2002 |    | 2001
|                 |  |                    |    |                  |  |      |    |     
|Americas         |  |                    | 71 | %                |  |      | 72 | %    |  |  | 71 | % |  |  | 72 | %
|EMEA             |  |                    | 15 | %                |  |      | 15 | %    |  |  | 15 | % |  |  | 15 | %
|Asia/Pacific Rim |  |                    | 14 | %                |  |      | 13 | %    |  |  | 14 | % |  |  | 13 | %

Revenues in Asia/Pacific Rim increased from 13% of total revenues in the
three months ended June 30, 2001 to 14% in the corresponding period of 2002 due
to continued strong growth in this region, fueled at least in part by the
visibility gained from its IPO in September 2001. The Americas revenue, as a
percentage of total revenue, decreased due to the reduction in sales of third
party products.

Costs and Expenses

Cost of product licenses and sales

Cost of revenues from product licenses and sales
consists of several components. Costs associated with
licensing our software products are minor. Substantially all of the cost of
product licenses and sales represents payments to partners for their products
that we integrate with our products or directly provide to our customers
as part of a single solution source. Costs of product revenues as a percentage
of total revenues decreased to 2% for the three months ended June 30, 2002 from
7% for the comparable period in 2001 and to 3% for the six months ended June
30, 2002 from 9% for the corresponding period in 2001, as sales of partner
software and hardware appliances representing a lower percentage of total
revenues. This decrease was the result of a reduction in sales of third party
products is consistent with our movement away from the direct sales of third-party
products, except where related to ISS managed services.

Cost of subscriptions and services

Cost of subscription and services includes the cost of our technical
support personnel who provide assistance to customers under maintenance
agreements, the security operations center (SOC) costs of providing managed
security monitoring services and the costs related to our professional services
and training. These costs decreased from 26% of revenues in the three months
ended June 30, 2001 to 22% of total revenues in the three months ended June 30,
2002. On a year-to-date basis these costs remained at 22% of total revenue in
2001 and 2002. In these periods, costs associated with professional services
decreased, while costs associated with our subscription revenue increased.

As a result of the difficult economic conditions combined with our effort
to focus on core professional services, costs associated with our professional
services and education services decreased, both in dollars and as a percentage
of total revenue. Costs were controlled through a reduction in personnel that
began in the third quarter of 2001, a narrowing of our consulting offerings to
focus on services that directly contribute to our protection platform strategy,
and a decrease in the number of training classes related to third party
products. We also continue to emphasize control over discretionary spending
and capital expenditures.

Costs associated with our technical support personnel and our security
operations centers increased in 2002 to handle our increasing customer base.
As our subscription revenue base increased we added personnel around the globe
to handle additional

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

customers under maintenance agreements and under managed security
monitoring services. We made an increased investment in automated systems and
personnel resources for our Asia/Pacific SOC, which began operating in the
third quarter of 2001.

Research and development

Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits, and
depreciation of computer equipment. These costs include those associated with
maintaining and expanding the X-Force, our internal team of security experts.

We believe our primary research and product development and managed service
offerings are important to retaining our leadership position in
the market. These expenses were 15% of revenue in the three months ended June
30, 2002, compared to 17% in the comparable period of 2001. On a year-to-date
basis these costs represented 15% of revenue in 2002 and 2001. We continue to
invest in available X-Force research capabilities that we believe to be a
differentiator for ISS. We intend to seek more leverage in the research and
development area while continuing to invest in the enhancement of current
technologies and the development of new technologies.

Sales and marketing

Sales and marketing expenses consist of salaries, travel expenses,
commissions, advertising, maintenance of our website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials.

These expenses were $23.9 million in both the three months ended June 30,
2002 and 2001, but decreased as a percentage of total revenues from 46% in 2001
to 41% in 2002. On a year-to-date basis these expenses remained at 40% of
total revenues. While absolute dollars remained consistent in each period
expenses associated with our direct sales force decreased as a result of
leverage achieved in our sales and marketing efforts by focusing our direct
sales force and continued expansion of the channel as a source of product
sales. The channel continues to be an important source of global revenue for
us as we use its capabilities to reach not just departmental and small
companies, but larger customers as well. These decreases were offset by an
increase in marketing, specifically advertising costs. Beginning in the first
quarter of 2002, and continuing into the second quarter of 2002, we launched our
first television and print advertising campaign designed to demonstrate the
multitude of threats that can compromise the security of a
companys networks,
servers or desktops. This campaign is aimed at increasing awareness of the
ISS brand, especially at the mainstream business market.

We intend to continue to expand our channel sales capabilities, focus on
controlling discretionary spending and capital expenditures and adjust our
organization in light of economic conditions. While we expect to
gain leverage in our sales and marketing costs in the future,
our ability to do so will be
largely dependent on economic and competitive conditions in future periods.

General and administrative

General and administrative expenses of $6.8 million in the second quarter
of 2002 and $5.1 million in the second quarter of 2001
represented approximately 11% of total revenues in 2002 and 10% in 2001. For
the quarter ended June 30, 2002, general and administrative
costs included
non-recurring expenses related to a relocation of our Asia/Pacific headquarters in Tokyo.
Excluding these non-recurring charges, general and administrative expenses
remained at 10% of total revenue in the three months ended June 30,
2002 compared to the same period of 2001.

On a year-to-date
basis, general and administrative expenses increased from 9% of total
revenues in 2001 to 10% in 2002, primarily due to the non-recurring relocation
expenses in Japan and our continued expansion of our general and administrative
support staff in the EMEA and Asia/Pacific regions as we focus on growth in
those areas. Other general and administrative expenses consist of
personnel-related costs for executive, administrative, finance and human
resources, information systems and other support services costs, and legal,
accounting and other professional service fees. The increase in these expenses
is also attributable to our continued efforts, through

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MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

additional employees and systems, to enhance our managements ability to
obtain and analyze information about our domestic and international operations,
and to support a larger employee base, as well as the expansion of our
facilities.

Charge for in-process research and development and write-off of lease obligation

Operating expenses
for the three-month and six-month periods ended June
30, 2001 included a $2.9 million charge for the write-off of in-process
research and development costs associated with the Network ICE acquisition in
June 2001. At that time, in-process research and development had not reached technological
feasibility based on identifiable technological risk factors which indicated
that even though successful completion was expected, it was not assured at the
acquisition date and was immediately charged to operations.

In the six months
ended June 30, 2001, we recorded a first quarter $1.1 million
write-off of the remaining lease obligation on our previous Atlanta
headquarters office space. This non-recurring expense originated in the first
quarter of 2001 as available subleased space in the area grew substantially in
that quarter as the result of layoffs, closures and consolidations by
many companies, decreasing the
prospects of subleasing our old space.

Amortization

We incurred amortization expense of $1.5 million and $1.1 million in the
three months ended June 30, 2002 and 2001, respectively. Amortization expense
for the six-month periods ended June 30, 2002 and 2001 was $3.0 million and
$1.3 million, respectively. In 2002, amortization relates to intangible assets
and stock-based compensation, resulting from acquisitions accounted for under
the purchase method. Beginning January 1, 2002, goodwill is no longer
amortized, but subject to periodic tests for impairment.

Interest income

Net interest income decreased from $1.8 million in the quarter ended June
30, 2001 to $872,000 in the comparable quarter of 2002, and from $3.8 million
in the six-months ended June 30, 2002 to $1.6 million in the corresponding
period of 2002, due to lower market rates of interest on interest bearing cash
equivalents and marketable securities. The market rate of interest paid on
investment-quality commercial paper and similar investments dropped from
approximately 4.4% during the second quarter of 2001 to approximately 2.1% in
the second quarter of 2002. As a result, interest income decreased despite an
increase in total cash and cash equivalents and interest-bearing marketable
securities.

Minority interest

Minority interest totaled $68,000 in the three months ended June 30, 2002
and $207,000 in the six months ended June 30, 2002. Minority interest expense
for the three months and six months ended June 30, 2001 was not material.
Minority interest represents the portion of earnings that would be distributed
to shares not held by us if the Asia/Pacific Rim subsidiary declared a dividend
equal to its earnings. In March 2001 we sold approximately 2% of the
outstanding shares of our Asia/Pacific Rim subsidiary to employees and key
partners. In September 2001, our Asia/Pacific Rim subsidiary sold newly issued
shares equal to approximately 10% of its previously outstanding shares in its
initial public offering on the Japan over-the counter market.

Other income

Other income reported in the three-month period ending June 30, 2002
consisted of a $1.9 million gain on the sale of an investment in an ISS
distributor in Japan. The shares of the publicly traded company were acquired
when the distributor was privately held and were subsequently sold on the open
market. The gain is substantially offset by expenses included in the general
and administrative category resulting from the consolidation of Tokyo-based
operations from several different locations to a new centralized headquarters
in Tokyo.

Included in pretax income in the six months ended June 30, 2001, is a
non-recurring other income item of $1.6 million generated from the sale of
approximately 2% of the outstanding shares of our Asia-Pacific subsidiary in
March 2001. As part of the planning for an IPO in Japan of a minority interest
in our Asia-Pacific subsidiary that was completed in September 2001, options
were granted in the subsidiary as a means of key employee retention and
approximately 2% of the outstanding shares were sold to employees and key
partners. The price was established based on a valuation of the company by an
independent appraisal firm. The gain represents the difference between proceeds
received and the underlying basis in the stock.

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Foreign currency exchange loss

The exchange loss of $100,000 and $77,000 in the three months and six
months ended June 30, 2002, respectively, and the exchange loss of $31,000 and
$282,000 in the three months and six months ended June 30, 2001, respectively,
is a result of fluctuations in currency exchange rates between the U.S. dollar
and other currencies, primarily the Japanese Yen and the Euro and changes in
value of assets and liabilities that are denominated in foreign currencies.

Provision for (benefit from) income taxes

The effective tax rate was 40% and 41% for the three and six months ended
June 30, 2002, respectively. For the comparable periods of 2001 the income tax
benefit was approximately 41% of pre-tax net loss for the quarter ended June
30, 2001 and 32% of pre-tax net income for the six months ended June 30, 2001.

Under APB Opinion No. 28, Interim Financial Reporting, we are required
to estimate the annual effective income tax rate each time an interim report is
issued. As of June 30, 2002, we estimated the annual effective income tax
rate for the calendar year 2002 to be 40%.

The effective tax rate for 2002 differs from the statutory rate primarily
due to the impact of acquisition related intangibles that are not deductible
for income tax purposes, primarily attributable to the acquisition of Network
ICE during the second quarter of 2001. The income tax calculation for the
second quarter of 2001 included the impact of goodwill amortization resulting
from the Network ICE acquisition that is no longer amortized, effective January
1, 2002 under Statement of Financial Accounting Standard No. 142.

While we record income tax expense on domestic income, domestic taxes
payable are reduced by deductions related to the employee exercise of stock
options. The tax benefit of these deductions was recorded as additional
paid-in capital. Taxes paid generally relate to our foreign operations.

Liquidity and Capital Resources

Net cash provided by operations in the first six months of 2002 was $12.8
million and included net income of $7.5 million, non-cash depreciation and
amortization expense charges of $10.1 million, income tax benefit from employee
exercises of stock options of $4.2 million and growth in deferred revenues of $1.8
million and was offset by a reduction in net assets and liabilities, excluding cash,
of $11.4 million.

Investing activities
in the first six months of 2002 included the purchase
of $42.3 million of marketable securities, primarily commercial paper, offset
by net proceeds from the maturity of marketable securities of $64.4 million.
These assets have quality characteristics similar to cash equivalents, except
their maturities when we acquire them are longer than three months. We also
invested in equipment totaling $7.9 million as we provided existing and new
personnel with improved computer hardware and incurred leasehold improvement
costs related primarily to a new Asia/Pacific headquarters in Tokyo.

Our financing activities provided $3.9 million of cash in the six months
ended June 30, 2002, which consisted of proceeds from the exercise of stock
options by our employees and from the issuance of common stock through our
Employee Stock Purchase Plan.

As of June 30, 2002, we had $174.0 million of cash and cash equivalents
and marketable securities, consisting primarily of money market accounts and
investment grade commercial paper. An additional $12.5 million of commercial
paper investments are pledged as collateral for stand-by letters of credit
related to the operating leases of our facilities and are shown on the balance
sheet as restricted cash. We believe that such cash and cash equivalents and
marketable securities will be sufficient to meet our working capital needs and
capital expenditures for the foreseeable future.

On July 18, 2002 we announced our plan to repurchase up to $50 million of our
stock utilizing cash on hand and cash flow generated from operations over the
next twelve months. We anticipate retaining a cash and marketable securities
balance of at least $120 million during this period. Other than this stock
repurchase, we are not aware of any trends, events or uncertainties that are
reasonably likely to result in any significant changes to our liquidity. From
time to time we evaluate possible acquisition and investment opportunities in
businesses, products or technologies that are complimentary to ours. In the
event we determine to pursue such opportunities, we may use our available cash
and cash equivalents. Pending such uses, we will continue to invest our
available cash in investment grade, interest-bearing investments.

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

We do not have any off-balance sheet financing arrangements or any
relationships with structured finance or special purpose entities. Other
than our non-cancelable operating leases for office space, we do not have any
contractual obligations that would impact our liquidity. Our payment for
operating leases is secured by three stand-by letters of credit totaling
approximately $10.6 million. The stand-by letters of credit are annually
renewable over the duration of the applicable leases. We do not anticipate
utilizing these stand-by letters of credit to provide any liquidity needs.

Risk Factors

Forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to known and unknown risks and uncertainties. Our forward-looking statements
contained in this Quarterly Report and elsewhere should be considered in light of the following important risk factors.
Variations from our stated intentions or failure to achieve objectives could
cause actual results to differ from those projected in our forward-looking
statements. We undertake no obligation to update publicly any forward-looking
statements for any reason, even if new information becomes available or other
events occur in the future.

We Operate in a Rapidly Evolving Market

We began operations in 1994 and achieved profitability in 1999. We operate
in a new and rapidly evolving market and must, among other things:



| |  |  | respond to competitive developments;                                  
| | - |  | ----------------------------------------------------------------------
|
| |  |  | continue to upgrade and expand our product and services offerings;
and
|
| |  |  | continue to attract, retain and motivate our employees.               

We cannot be certain
that we will successfully address these issues. As a
result, we cannot assure our investors that we will be able to continue to
operate profitably in the future.

Our Future Operating Results Will Likely Fluctuate Significantly

As a result of our limited operating history,
we cannot predict our future revenues and operating results with certainty. However, we do expect
our future revenues and operating results to fluctuate due to a combination of factors, including:



| |  |  | the growth in the acceptance of, and activity on, the Internet and
the World Wide Web, particularly by corporate, institutional and
government users;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the extent to which the public perceives that unauthorized access to
and use of online information are threats to network security;                  
|
| |  |  | the volume and timing of orders, including seasonal trends in
customer purchasing;                                                                   
|
| |  |  | our ability to develop new and enhanced product and managed service
offerings and expand our professional services capabilities;                     
|
| |  |  | our ability to provide scalable managed services offerings through
our partners in a cost effective manner;                                          
|
| |  |  | foreign currency exchange rates that affect our international
operations;                                                                            
|
| |  |  | product and price competition in our markets; and                                                                                                    
|
| |  |  | general economic conditions, both domestically and in our foreign
markets.                                                                           

We increasingly focus our efforts on sales of enterprise-wide security
solutions, which consist of our entire product suite and related professional
services, and managed security services, rather than on the sale of component
products. As a result, each sale may require additional time and effort from
our sales and support staff. In addition, the revenues associated with
particular sales vary significantly depending on the number of products
licensed by a customer, the number of devices used by the customer and the

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MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

customers relative need for our professional services. Large individual
sales, or even small delays in customer orders, can cause significant variation
in our license revenues and results of operations for a particular period. The
timing of large orders is usually difficult to predict and, like many software
and services companies, many of our customers typically complete transactions
in the last month of a quarter.

We cannot predict our operating expenses based on our past results.
Instead, we establish our spending levels based in large part on our expected
future revenues. As a result, if our actual revenues in any future period fall
below our expectations, our operating results likely will be adversely affected
because very few of our expenses vary with our revenues. Because of the factors
listed above, we believe that our quarterly and annual revenues, expenses and
operating results likely will vary significantly in the future.

Our ability to provide timely guidance and meet the expectations of
investors, industry analysts and brokerage firms with respect to our operating
and financial results is impacted by the tendency of a majority of our sales to
be completed in the last month of a quarter. We may not be able to determine
whether we will experience material deviations from guidance or expectations
until the end of a quarter.

We Face Intense Competition in Our Market

The market for network security monitoring, detection and response
solutions is intensely competitive, and we expect competition to increase in
the future. We cannot guarantee that we will compete successfully against our
current or potential competitors, especially those with significantly greater
financial resources or brand name recognition. Our chief competitors generally
fall within one of five categories:



| |  |  | internal information technology departments of our customers and the
consulting firms that assist them in formulating security systems;                                                                                                                               
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | relatively smaller software companies offering relatively limited
applications for network and Internet security;                                                                                                                                                     
|
| |  |  | large companies, including Symantec Corp., Cisco Systems, Inc. and
Enterasys Networks, Inc., that sell competitive products and offerings,
as well as other large software companies that have the technical
capability and resources to develop competitive products;
|
| |  |  | software or hardware companies like Cisco Systems, Inc. that could
integrate features that are similar to our products into their own
products; and                                                                                                                   
|
| |  |  | small and large companies with competitive offerings to components of
our managed services offerings.                                                                                                                                                                 

Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, would make such combined entities
potentially more formidable competitors to us if such products and offerings
are effectively integrated. Large companies may have advantages over us because
of their longer operating histories, greater name recognition, larger customer
bases or greater financial, technical and marketing resources. As a result,
they may be able to adapt more quickly to new or emerging technologies and
changes in customer requirements. They can also devote greater resources to the
promotion and sale of their products than we can. In addition, these companies
have reduced and could continue to reduce, the price of their security
monitoring, detection and response products and managed security services,
which increases pricing pressures within our market.

Several companies currently sell software products (such as encryption,
firewall, operating system security and virus detection software) that our
customers and potential customers have broadly adopted. Some of these companies
sell products that perform the same functions as some of our products. In
addition, the vendors of operating system software or networking hardware may
enhance their products to include the same kinds of functions that our products
currently provide. The widespread inclusion of comparable features to our
software in operating system software or networking hardware could render our
products obsolete, particularly if such features are of a high quality. Even if
security functions integrated into operating system software or networking
hardware are more limited than those of our software, a significant number of
customers may accept more limited functionality to avoid purchasing additional
software.

For the above reasons, we may not be able to compete successfully against
our current and future competitors. Increased competition may result in price
reductions, reduced gross margins and loss of market share.

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

We Must Attract and Retain Personnel While Competition for Personnel in Our Industry is Intense

Competition for talented personnel in the software, network consulting and
managed services industries is intense. We believe our future success will
depend in part on our ability to recruit and retain highly skilled engineering,
technical, consulting, marketing, sales and management personnel. To accomplish
this, we believe we must provide competitive compensation.

We Face Rapid Technological Change in Our Industry and Frequent Introductions of New Products

Rapid changes in technology pose significant risks to us. We do not
control nor can we influence the forces behind these changes, which include:



| |  |  | the extent to which businesses and others seek to establish more
secure networks;
| | - |  | ---------------------------------------------------------------------------------
|
| |  |  | the extent to which hackers and others seek to compromise secure
systems;        
|
| |  |  | evolving computer hardware and software standards;                               
|
| |  |  | changing customer requirements; and                                              
|
| |  |  | frequent introductions of new products and product enhancements.                 

To remain successful, we must continue to change, adapt and improve our
products in response to these and other changes in technology. Our future
success hinges on our ability to both continue to enhance our current line of
products and professional services and to introduce new products and services
that address and respond to innovations in computer hacking, computer
technology and customer requirements. We cannot be sure that we will
successfully develop and market new products that do this. Any failure by us to
timely develop and introduce new products, to enhance our current products or
to expand our professional services capabilities in response to these changes
could adversely affect our business, operating results and financial condition.

Our products involve very complex technology, and as a consequence, major
new products and product enhancements require a long time to develop and test
before going to market. Because this amount of time is difficult to estimate,
we have had to delay the scheduled introduction of new and enhanced products in
the past and may have to delay the introduction of new and enhanced products
enhancements in the future.

The techniques computer hackers use to gain unauthorized access to, or to
sabotage, networks and intranets are constantly evolving and increasingly
sophisticated. Furthermore, because new hacking techniques are usually not
recognized until used against one or more targets, we are unable to anticipate
most new hacking techniques. To the extent that new hacking techniques harm our
customers computer systems or businesses, affected or prospective customers may believe that
our products are ineffective, which may cause them or prospective customers to
reduce or avoid purchases of our products.

Risks Associated with Our Global Operations

The expansion of our international operations includes our presence in
dispersed locations throughout the world, including throughout Europe and the
Asia/Pacific and Latin America regions. Our international presence and
expansion exposes us to risks not present in our U.S. operations, such as:



| |  |  | the difficulty in managing an organization spread over various
countries located across the world;                                            
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | compliance with, and unexpected changes in, a wide range of complex
regulatory requirements in countries where we do business;                
|
| |  |  | increased financial accounting and reporting burdens and complexities
and potentially adverse tax consequences;                               
|
| |  |  | excess taxation due to overlapping tax structures;                                                                                            
|
| |  |  | fluctuations in foreign currency exchange rates resulting in losses
or gains from transactions and expenses denominated in
foreign currencies;
|
| |  |  | reduced protection for intellectual property rights in some
countries; and                                                                    
|
| |  |  | export license requirements and restrictions on the export of certain
technology, especially encryption technology and trade restrictions.    

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Despite these risks, we believe that we must continue to expand our
operations in international markets to support our growth. To this end, we
intend to establish additional foreign sales operations, expand our existing
offices, hire additional personnel, expand our international sales channels and
customize our products for local markets. If we fail to execute this strategy,
our international sales growth will be limited.

Our Networks, Products and Services May be Targeted by Hackers

Like other companies, our websites, networks, information systems,
products and services may be targets for sabotage, disruption or
misappropriation by hackers. As a leading network security solutions company,
we are a high profile target. Although we believe we have sufficient controls
in place to prevent disruption and misappropriation, and to respond to
situations, we expect these efforts by hackers to continue. If these efforts
are successful, our operations, reputation and sales could be adversely
affected.

We Must Successfully Integrate Acquisitions

As part of our growth strategy, we have and may continue to acquire or
make investments in companies with products, technologies or professional
services capabilities complementary to our solutions. When engaging in
acquisitions, we could encounter difficulties in assimilating new personnel and
operations into our company. These difficulties may disrupt our ongoing
business, distract our management and employees, increase our expenses and
adversely affect our results of operations. These difficulties could also
include accounting requirements, such as impairment charges related to goodwill
or expensing in-process research and development costs. We cannot be certain
that we will successfully overcome these risks with respect to any future
acquisitions or that we will not encounter other problems in connection with
our recent or any future acquisitions. In addition, any future acquisitions may
require us to incur debt or issue equity securities. The issuance of equity
securities could dilute the investment of our existing stockholders.

We Depend on Our Intellectual Property Rights and Use Licensed Technology

We rely primarily on copyright and trademark laws, trade secrets,
confidentiality procedures and contractual provisions to protect our
proprietary rights. We have obtained one United States patent and have 15 patent applications under review. We also believe that the technological and
creative skills of our personnel, new product developments, frequent product
enhancements, our name recognition, our professional services capabilities and
delivery of reliable product maintenance are essential to establishing and
maintaining our technology leadership position. We cannot assure you that our
competitors will not independently develop technologies that are similar to
ours.

Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy aspects of our products or to obtain and use
information that we regard as proprietary. Policing unauthorized use of our
products is difficult. While we cannot determine the extent to which piracy of
our software products occurs, we expect software piracy to be a persistent
problem. In addition, the laws of some foreign countries do not protect our
proprietary rights to as great an extent as do the laws of the United States
and many foreign countries do not enforce these laws as diligently as U.S.
government agencies and private parties.

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS




ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Item 7a.   Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity

The primary objective of our investment activities is to preserve principal
while at the same time maximize the income we receive from our investments
without significantly increasing risk. Some of the securities that we have
invested in may be subject to market risk. This means that a change in
prevailing interest rates may cause the principal amount of the investment to
fluctuate. For example, if we hold a security that was issued with a fixed
interest rate at the then-prevailing rate and the prevailing interest rate
later rises, the market value of our investment will probably decline. To
minimize this risk, we maintain our portfolio of cash equivalents and
marketable securities in a variety of relatively short-term investments,
including commercial paper and overnight repurchase agreements. Our marketable
securities at June 30, 2002 mature as follows: $3.9 million
within three months,
$22.9 million in three to six months and $5.9 million in more than six months.

Risk Associated with Foreign Exchange Rates

We are subject to foreign exchange risk as a result of exposures to
changes in currency exchange rates. Our foreign operations are, for the most
part, naturally hedged against exchange rate fluctuations since both revenues
and expenses of each foreign affiliate are denominated in the same currency. As
a result, an unfavorable change in the exchange rate for any particular foreign
subsidiary would result in lower revenues and expenses with regards to
operating results, and lower assets and liabilities with regards to the balance
sheet. Therefore, we do not engage in formal hedging activities, but we do
periodically review the potential impact of this risk to ensure that the risk
of significant potential losses remains minimal.




PART II   OTHER INFORMATION




ITEM 1.   LEGAL PROCEEDINGS

Beginning on September 28, 2001, the Company and certain of its officers
and directors were named as defendants in several lawsuits alleging violations
of the federal securities laws, including Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and Rule 10b-5 thereunder. As of
March 27, 2002, six such actions have been filed in the United States District
Court for the Northern District of Georgia. The complaints, which are
substantially similar in nature, purport to be brought on behalf of a class of
investors who purchased the Companys stock during the period from April 5,
2001 through August 14, 2001 (the Class Period). The complaints generally
allege that the Company and the individual defendants violated the anti-fraud
provisions of the federal securities laws and caused the Companys stock to
trade at artificially high prices by making misrepresentations relating to the
Companys financial condition and prospects during the Class Period. The
complaints seek damages in an unspecified amount. All six actions
have been consolidated into a single case and the court has appointed
lead plaintiffs and lead plaintiffs counsel. The
Company expects that the plaintiffs will file a consolidated, amended
complaint. No answer or other
responsive papers are yet due from the defendants. The Company believes that it
has meritorious defenses and intends to defend the actions vigorously.




ITEM 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS

On July 11, 2002, the Board of Directors adopted a shareholder rights
plan and authorized and declared a dividend of one preferred share
purchase right (a Right) for each outstanding share of
common stock, par value $.001 per share, of the Company. The dividend
was paid on July 29, 2002 to the stockholders of record on that
date. Stock issued subsequent to July 29, 2002 will be issued
with an attached Right. Each Right will initially represent the
rights, under certain circumstances, to purchase one one-thousandth
of a share of Series A Junior Participating Preferred Stock (the
Junior Preferred Stock) at a purchase price of $80 per
one one-thousandth of a share. If a person or group acquires
beneficial ownership of 20% or more of the then outstanding shares of
the Company's common stock (an Acquiring Person''), the holder
of a Right, upon exercise of the Right, will thereafter have the
right to receive, in lieu of shares of Junior Preferred Stock, shares
of the Company's common stock (or, in certain circumstances, cash,
property or other securities of the Company) having a value equal to
twice the purchase price of the Right.

The Rights expire on
July 11, 2012. Generally, the Board of Directors may redeem the
Rights at a price of $.001 per Right (subject to adjustment) at any
time prior to the earlier of (i) the close of business on the
tenth business day following the Shares Acquisition Date (as defined
in the rights plan) or (ii) the expiration date of the Rights.
Prior to any person or group becoming an Acquiring Person, the
Company may amend the Rights Agreement at any time.




ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Stockholders of Internet Security Systems, Inc. was held on Wednesday, May 29, 2002.

The following two directors were elected to serve a three-year term ending
in the year 2005: (a) Richard S. Bodman, 42,113,700 votes for and 395,908 votes
withheld, and (b) Kevin J. OConnor, 42,257,284 votes for and 252,324 votes
withheld.

Our Restated 1995 Stock Incentive Plan was amended to prohibit certain
amendments to the plan without stockholder approval and to change the Automatic
Option Grant Program for non-employee directors by reducing the initial grant
to non-employee directors to 20,000 options and increasing the annual grant to non-employee
directors to 10,000 options. The vote was as follows: (a) Voting For: 25,783,653, (b) Voting
Against: 16,712,609, (c) Abstentions: 13,345. There were no broker non-votes for purposes
of this proposal.

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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS




ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

|    |  |                                                                |   |                                                                                                                                                                           
|--- |  | -------------------------------------------------------------- | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Exhibits.                                                     
|   
|    |  | 3.1                                                            |  | Restated
Certificate of Incorporation (filed as Exhibit 3.1 to the Companys
Quarterly Report on Form 10-Q, dated November 14, 2000 and
incorporated by reference herein).
|   
|    |  | 3.2                                                            |  | Bylaws (filed as
Exhibit 3.2 to the Companys Registration Statement on Form S-1,
Registration No. 333-44529 and incorporated by reference herein).                       
|   
|    |  | 11                                                             |  | Computation of
Per Share Earnings.*                                                                                                                                       
|   
|    |  | 99.1                                                           |  | Certification
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.                                                   
|   
|    |  | 99.2                                                           |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.                                                   
|   
|(b) |  | Reports on Form 8-K.                                          
|   
|    |  | ISS filed no reports on Form 8-K during this reporting period.



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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

INTERNET SECURITY SYSTEMS, INC. SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

|                      |  |                                 |  |                                                                   
|--------------------- |  | ------------------------------- |  | ------------------------------------------------------------------
|                      |  | INTERNET SECURITY SYSTEMS, INC.
|                      |  |                                
|                      |  |                                
|                     
|Date: August 13, 2002 |  | By                              |  | /s/ Richard Macchia                                               
|                      |  |                                 |  |                                                                   
|                      |  |                                 |  | Chief Financial Officer
Vice President and Chief Financial Officer
|                     
|                      |  |                                 |  | (Duly Authorized
Officer and PrincipalFinancial Officer)          
|                     
|                      |  | By                              |  | /s/ Maureen Richards                                              
|                      |  |                                 |  |                                                                   
|                      |  |                                 |  | Corporate Controller                                              
|                      |  |                                 |  | (Chief Accounting Officer)