##### 



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 endedSeptember 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 000-23655

INTERNET SECURITY SYSTEMS, INC.



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

6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328

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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.

|                               |  |                             
|------------------------------ |  | ----------------------------
|                               |  | Number of Shares Outstanding
|Title of each class            |  | as of November 8, 2002      
|Common Stock, $0.001 par value |  | 49,496,000                  





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TABLE OF CONTENTS

|                                                                                             |                                                                                                                            |  |        |   | 
|-------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------- |  | ------ | - | 
|                                                                                             |                                                                                                                            |  | PAGE  
|                                                                                             |                                                                                                                            |  | NUMBER
|                                                                                             |                                                                                                                            |  |       
|PART
I. FINANCIAL INFORMATION                                                                |                                                                                                                            |  |        |  
|Item 1 Consolidated Financial Statements:                                                    |                                                                                                                            |  |        |  
|                                                                                             | Consolidated Balance Sheets at September 30, 2002 and December 31, 2001                                                    |  |        | 3 | 
|                                                                                             | Consolidated Statements of Operations for the three months and nine months ended
September 30, 2002 and September 30, 2001 |  |        | 4 | 
|                                                                                             | Consolidated Statements of Cash Flows for the nine months ended September 30,
2002 and September 30, 2001                  |  |        | 5 | 
|                                                                                             | Notes to Consolidated Financial Statements                                                                                 |  |        | 6 | 
|Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations |                                                                                                                            |  | 11     |  
|Item 3 Quantitative and Qualitative Disclosures about Market Risk                            |                                                                                                                            |  | 24     |  
|Item 4 Controls and Procedures                                                               |                                                                                                                            |  | 24     |  
|PART II. OTHER INFORMATION                                                                   |                                                                                                                            |  | 24     |  
|Item 1 Legal Proceedings                                                                     |                                                                                                                            |  | 24     |  
|Item 6 Exhibits and Reports on Form 8-K                                                      |                                                                                                                            |  | 26     |  

2



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##### 



INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share amounts)

|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |              |         |         |         | 
|----------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------- | ------------------------- | ----------------------------------------- | ------- | ------------- | ------- | ------------ | ------- | ------- | ------- | 
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         | September 30, |         | December 31,
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         | 2002          |         | 2001        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         | (UNAUDITED)   |         |              |        
|                                                                                    |                                                                                                                              |                                               |                           | ASSETS                                    |         |               |         |              |         |         |         | 
|Current assets:                                                                     |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    | Cash and cash equivalents                                                                                                    |                                               | $                         | 123,699                                   |         |               | $       | 108,038      |        
|                                                                                    | Marketable securities                                                                                                        |                                               |                           | 54,792                                    |         |               |         | 55,129       |        
|                                                                                    | Accounts receivable, less allowance for doubtful accounts of $2,612 and
$2,563, respectively                                 |                                               |                           | 63,102                                    |         |               |         | 50,259       |        
|                                                                                    | Inventory                                                                                                                    |                                               |                           | 2,273                                     |         |               |         | 1,768        |        
|                                                                                    | Prepaid expenses and other current assets                                                                                    |                                               |                           | 6,280                                     |         |               |         | 6,018        |        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               | Total current assets      |                                           |         | 250,146       |         |              |         | 221,212 |        
|Property and equipment:                                                             |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    | Computer equipment                                                                                                           |                                               |                           | 36,591                                    |         |               |         | 31,043       |        
|                                                                                    | Office furniture and equipment                                                                                               |                                               |                           | 22,287                                    |         |               |         | 20,872       |        
|                                                                                    | Leasehold improvements                                                                                                       |                                               |                           | 20,258                                    |         |               |         | 17,835       |        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               | 79,136                    |                                           |         |               | 69,750  |             
|                                                                                    | Less accumulated depreciation                                                                                                |                                               |                           | 36,035                                    |         |               |         | 25,254       |        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               | 43,101                    |                                           |         |               | 44,496  |             
|Restricted marketable securities                                                    |                                                                                                                              |                                               | 12,500                    |                                           |         |               | 12,500  |             
|Goodwill, less accumulated amortization of $27,381                                  |                                                                                                                              |                                               | 200,464                   |                                           |         |               | 197,060 |             
|Other intangibles, less accumulated amortization of $8,030 and $4,644, respectively |                                                                                                                              |                                               | 15,384                    |                                           |         |               | 19,722  |             
|Other assets                                                                        |                                                                                                                              |                                               | 9,296                     |                                           |         |               | 5,994   |             
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    | Total assets                                                                                                                 |                                               | $                         | 530,891                                   |         |               | $       | 500,984      |        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                   
|                                                                                    |                                                                                                                              |                                               |                           | LIABILITIES AND STOCKHOLDERS EQUITY      |         |               |         |              |         |         |         | 
|Current liabilities:                                                                |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    | Accounts payable                                                                                                             |                                               | $                         | 2,803                                     |         |               | $       | 3,553        |        
|                                                                                    | Accrued expenses                                                                                                             |                                               |                           | 20,591                                    |         |               |         | 20,440       |        
|                                                                                    | Deferred revenues                                                                                                            |                                               |                           | 52,092                                    |         |               |         | 48,139       |        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               | Total current liabilities |                                           |         | 75,486        |         |              |         | 72,132  |        
|Other non-current liabilities                                                       |                                                                                                                              |                                               | 2,290                     |                                           |         |               | 1,917   |             
|Commitments
and contingenciesStockholders 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,
48,481,000 and 47,871,000 issued and outstanding, respectively |                                               |                           | 48                                        |         |               |         | 48           |        
|                                                                                    |                                                                                                                              | Additional paid-in capital                    |                           |                                           | 442,037 |               |         |              | 430,449 |        
|                                                                                    |                                                                                                                              | Deferred compensation                         |                           |                                           | (745    | )             |         |              | (1,985  | )      
|                                                                                    |                                                                                                                              | Accumulated other comprehensive loss          |                           |                                           | (806    | )             |         |              | (2,312  | )      
|                                                                                    |                                                                                                                              | Retained earnings                             |                           |                                           | 14,570  |               |         |              | 735     |        
|                                                                                    |                                                                                                                              | Less treasury stock, at cost (130,000 shares) |                           |                                           | (1,989  | )             |         |              |        |        
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               |                           | Total stockholders equity                |         |               | 453,115 |              |         |         | 426,935 | 
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             
|                                                                                    |                                                                                                                              |                                               |                           | Total liabilities and stockholdersequity |         | $             | 530,891 |              |         | $       | 500,984 | 
|                                                                                    |                                                                                                                              |                                               |                           |                                           |         |               |         |             

3



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##### 



INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share amounts)
(Unaudited)

|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |        |        | 
|--------------------------------------------------- | -------------------------------------------------------------- | --------------------------------------- | ------ | ------------------ | ------ | ----------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                    |                                                                |                                         |        | Three months ended |        | Nine months ended
|                                                    |                                                                |                                         |        | September 30,      |        | September 30,    
|                                                    |                                                                |                                         |        |                    |        |                  
|                                                    |                                                                |                                         |        | 2002               |        | 2001              |         | 2002   |        | 2001
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |     
|Revenues:                                           |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    | Product licenses and sales                                     |                                         | $      | 30,150             |        |                   | $       | 27,435 |        |      | $       | 90,550 |        |   | $       | 91,699 |       
|                                                    | Subscriptions                                                  |                                         |        | 24,153             |        |                   |         | 17,663 |        |      |         | 67,263 |        |   |         | 48,259 |       
|                                                    | Professional services                                          |                                         |        | 7,465              |        |                   |         | 7,636  |        |      |         | 22,363 |        |   |         | 25,641 |       
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    |                                                                |                                         | 61,768 |                    |        |                   | 52,734  |        |        |      | 180,176 |        |        |   | 165,599 |       
|Costs and expenses:                                 |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    | Cost of revenues:                                              |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |        |       
|                                                    |                                                                | Product licenses and sales              |        |                    | 1,928  |                   |         |        | 1,401  |      |         |        | 5,599  |   |         |        | 11,552 | 
|                                                    |                                                                | Subscriptions and professional services |        |                    | 12,766 |                   |         |        | 12,788 |      |         |        | 38,637 |   |         |        | 38,083 | 
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    |                                                                | Total cost of revenues                  |        |                    | 14,694 |                   |         |        | 14,189 |      |         |        | 44,236 |   |         |        | 49,635 | 
|                                                    | Research and development                                       |                                         |        | 8,692              |        |                   |         | 9,276  |        |      |         | 26,120 |        |   |         | 26,531 |       
|                                                    | Sales and marketing                                            |                                         |        | 23,780             |        |                   |         | 23,449 |        |      |         | 70,369 |        |   |         | 68,996 |       
|                                                    | General and administrative                                     |                                         |        | 5,918              |        |                   |         | 5,509  |        |      |         | 18,194 |        |   |         | 15,105 |       
|                                                    | Charge for in-process research and development                 |                                         |        |                   |        |                   |         |       |        |      |         |       |        |   |         | 2,910  |       
|                                                    | Write-off of lease obligation                                  |                                         |        |                   |        |                   |         |       |        |      |         |       |        |   |         | 1,072  |       
|                                                    | Amortization of other intangibles and stock-based
compensation |                                         |        | 1,326              |        |                   |         | 2,213  |        |      |         | 4,286  |        |   |         | 3,451  |       
|                                                    | Amortization of goodwill                                       |                                         |        |                   |        |                   |         | 11,393 |        |      |         |       |        |   |         | 15,597 |       
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    |                                                                |                                         | 54,410 |                    |        |                   | 66,029  |        |        |      | 163,205 |        |        |   | 183,297 |       
|Operating income (loss)                             |                                                                |                                         | 7,358  |                    |        |                   | (13,295 | )      |        |      | 16,971  |        |        |   | (17,698 | )     
|Interest income, net                                |                                                                |                                         | 877    |                    |        |                   | 1,524   |        |        |      | 2,479   |        |        |   | 5,274   |       
|Minority interest                                   |                                                                |                                         | (66    | )                  |        |                   | (156    | )      |        |      | (273    | )      |        |   | (156    | )     
|Other income                                        |                                                                |                                         | 2,068  |                    |        |                   | 13,620  |        |        |      | 3,904   |        |        |   | 15,258  |       
|Foreign currency exchange gain (loss)               |                                                                |                                         | 145    |                    |        |                   | (163    | )      |        |      | 68      |        |        |   | (445    | )     
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|Income before income taxes                          |                                                                |                                         | 10,382 |                    |        |                   | 1,530   |        |        |      | 23,149  |        |        |   | 2,233   |       
|Provision for income taxes                          |                                                                |                                         | 4,041  |                    |        |                   | 7,618   |        |        |      | 9,314   |        |        |   | 7,390   |       
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|Net income (loss)                                   |                                                                | $                                       | 6,341  |                    |        | $                 | (6,088  | )      |        | $    | 13,835  |        |        | $ | (5,157  | )     
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|Basic net income (loss) per share of Common Stock   |                                                                | $                                       | 0.13   |                    |        | $                 | (0.13   | )      |        | $    | 0.29    |        |        | $ | (0.12   | )     
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|Diluted net income (loss) per share of Common
Stock |                                                                | $                                       | 0.13   |                    |        | $                 | (0.13   | )      |        | $    | 0.28    |        |        | $ | (0.12   | )     
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|Weighted average shares:                            |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    | Basic                                                          |                                         |        | 48,393             |        |                   |         | 47,693 |        |      |         | 48,080 |        |   |         | 44,764 |       
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       
|                                                    | Diluted                                                        |                                         |        | 48,855             |        |                   |         | 47,693 |        |      |         | 48,865 |        |   |         | 44,764 |       
|                                                    |                                                                |                                         |        |                    |        |                   |         |        |        |      |         |        |        |   |         |       

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INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)

|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |   |         |         |  
|---------------------------------------------------------------------------------------- | ------------------------------------------------------------------------ | ----------------------------------------- | -------------------------------------------------------------- | - | ----------------- | ------- | ------- | - | ------- | ------- | -
|                                                                                         |                                                                          |                                           |                                                                |   | Nine months ended
|                                                                                         |                                                                          |                                           |                                                                |   | September 30,    
|                                                                                         |                                                                          |                                           |                                                                |   |                  
|                                                                                         |                                                                          |                                           |                                                                |   | 2002              |         | 2001   
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |        
|OPERATING
ACTIVITIESNet income (loss)                                                    |                                                                          | $                                         | 13,835                                                         |   |                   | $       | (5,157  | )
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |                                                                          |                                           |                                                                |   |                   |         |         |  
|                                                                                         |                                                                          |                                           | Depreciation                                                   |   |                   | 10,781  |         |   |         | 8,135   |  
|                                                                                         |                                                                          |                                           | Amortization of goodwill                                       |   |                   |        |         |   |         | 15,597  |  
|                                                                                         |                                                                          |                                           | Amortization of other intangibles and stock-based compensation |   |                   | 4,286   |         |   |         | 3,451   |  
|                                                                                         |                                                                          |                                           | Accretion of discount on marketable securities                 |   |                   | 230     |         |   |         | 175     |  
|                                                                                         |                                                                          |                                           | Minority interest                                              |   |                   | 273     |         |   |         | 156     |  
|                                                                                         |                                                                          |                                           | Charge for in-process research and development                 |   |                   |        |         |   |         | 2,910   |  
|                                                                                         |                                                                          |                                           | Income tax benefit from exercise of stock options              |   |                   | 6,952   |         |   |         | 9,398   |  
|                                                                                         |                                                                          |                                           | Gain on issuance of subsidiary stock                           |   |                   | (2,560  | )       |   |         |        |  
|                                                                                         |                                                                          |                                           | Gain on sale of subsidiary stock                               |   |                   |        |         |   |         | (15,252 | )
|                                                                                         |                                                                          |                                           | Other non-cash items                                           |   |                   |        |         |   |         | 67      |  
|                                                                                         | Changes in assets and liabilities, excluding the effect of acquisitions: |                                           |                                                                |   |                   |         |         |   |        
|                                                                                         |                                                                          |                                           | Accounts receivable                                            |   |                   | (11,566 | )       |   |         | 1,271   |  
|                                                                                         |                                                                          |                                           | Inventory                                                      |   |                   | (505    | )       |   |         | 147     |  
|                                                                                         |                                                                          |                                           | Prepaid expenses and other assets                              |   |                   | (3,377  | )       |   |         | (6,723  | )
|                                                                                         |                                                                          |                                           | Accounts payable and accrued expenses                          |   |                   | (2,215  | )       |   |         | (6,214  | )
|                                                                                         |                                                                          |                                           | Deferred revenues                                              |   |                   | 5,480   |         |   |         | 8,059   |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  
|                                                                                         |                                                                          | NET CASH PROVIDED BY OPERATING ACTIVITIES |                                                                |   | 21,614            |         |         |   | 15,864  |        
|INVESTING
ACTIVITIES
Acquisitions, net of cash received                                  |                                                                          |                                           | (1,348                                                         | ) |                   |         | (7,495  | )
|Net proceeds from maturity of marketable securities                                      |                                                                          |                                           | 63,315                                                         |   |                   |         | 105,492 |  
|Purchases of marketable securities                                                       |                                                                          |                                           | (63,208                                                        | ) |                   |         | (98,127 | )
|Purchases of property and equipment                                                      |                                                                          |                                           | (9,207                                                         | ) |                   |         | (26,683 | )
|Net proceeds from sale of subsidiary stock                                               |                                                                          |                                           |                                                               |   |                   |         | 16,529  |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  
|                                                                                         |                                                                          | NET CASH USED IN INVESTING ACTIVITIES     |                                                                |   | (10,448           | )       |         |   | (10,284 | )      
|FINANCING
ACTIVITIES
Proceeds from exercise of stock options                             |                                                                          |                                           | 2,892                                                          |   |                   |         | 13,105  |  
|Proceeds from issuance of common stock                                                   |                                                                          |                                           | 2,086                                                          |   |                   |         | 2,250   |  
|Purchase of treasury shares                                                              |                                                                          |                                           | (1,989                                                         | ) |                   |         |        |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  
|                                                                                         |                                                                          | NET CASH PROVIDED BY FINANCING ACTIVITIES |                                                                |   | 2,989             |         |         |   | 15,355  |        
|Foreign currency impact on cash                                                          |                                                                          |                                           | 1,506                                                          |   |                   |         | 678     |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  
|Net increase in cash and cash equivalents                                                |                                                                          |                                           | 15,661                                                         |   |                   |         | 21,613  |  
|Cash and cash equivalents at beginning of period                                         |                                                                          |                                           | 108,038                                                        |   |                   |         | 66,210  |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  
|Cash and cash equivalents at end of period                                               |                                                                          | $                                         | 123,699                                                        |   |                   | $       | 87,823  |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  
|SUPPLEMENTAL
CASH FLOW DISCLOSURE
Income taxes paid                                      |                                                                          | $                                         | 2,770                                                          |   |                   | $       |        |  
|                                                                                         |                                                                          |                                           |                                                                |   |                   |         |         |  

5



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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 September 30, 2002 and for the three and nine months ended
September 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 nine months ended September 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.  Business Combinations

On August 1, 2002 Internet Security Systems KK, our Asia-Pacific
subsidiary, acquired a primary ISS KK distributor in Singapore, TriSecurity
Holdings Pte Ltd. This acquisition provides our Asia-Pacific subsidiary direct
support capabilities for their customers in Southeast Asia and allows ISS KK to
expand its capabilities in this growing market. The consideration consisted of
1,000 shares of ISS KK stock and approximately $1.2 million of cash. Goodwill
of approximately $4.0 million related to the purchase was recorded. There is
additional annual contingent consideration dependent on the achievement of
specified increasing levels of revenues and operating profits for the years
2002 through 2004. The total maximum additional consideration is 735 shares of
ISS KK stock and will be recorded as additional purchase price.

The operating results of ISS include the operating results of TriSecurity
Holdings Pte Ltd. since the date of acquisition.

3.  Other income and expense

Other income for the third quarter of 2002 includes a $2.6 million gain
related to the issuance of subsidiary shares in connection with the acquisition
of TriSecurity Holdings Pte Ltd. The Company reported a gain on the difference
between the fair market value of the shares issued and the book value of those
shares, in accordance with Staff Accounting Bulletin No. 51 and company policy.

In the nine months ended September 30, 2002, other income also consists of
a second quarter gain of $1.9 million 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 second quarter 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.

Other income for the three and nine months ended September 30, 2001
includes a subsidiary IPO gain of $13.6 million from an initial public offering
on the Japan over-the-counter market by the Companys subsidiary responsible
for Asia-Pacific operations. Proceeds of the IPO were retained by the
subsidiary.

In the nine months ended September 30, 2001, other income included a
second quarter non-recurring other income item of $1.6 million 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

6



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##### 



INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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 quarter ended March 31, 2001, the Company recorded a $1.1 million
write-off of the remaining lease obligation on our previous Atlanta office
space. This non-recurring expense originated in the first 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.

4.  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):

|                               |                        |       |   |                    |        |                   |   |                |        |              |   |         |        |  |   |         |        |  
|------------------------------ | ---------------------- | ----- | - | ------------------ | ------ | ----------------- | - | -------------- | ------ | ------------ | - | ------- | ------ |  | - | ------- | ------ | -
|                               |                        |       |   | September 30, 2002 |        | December 31, 2001
|                               |                        |       |   | Gross Carrying     |        | Accumulated       |   | Gross Carrying |        | Accumulated 
|                               |                        |       |   | Amount             |        | Amortization      |   | Amount         |        | Amortization
|                               |                        |       |   |                    |        |                   |   |                |        |             
|Unamortized intangible assets: |                        |       |   |                    |        |                   |   |                |        |              |   |         |        |  |   |        
|                               | Goodwill               |       | $ | 227,845            |        |                   | $ | (27,381        | )      |              | $ | 224,441 |        |  | $ | (27,381 | )     
|                               |                        |       |   |                    |        |                   |   |                |        |              |   |         |        |  |   |        
|Amortized intangible assets:   |                        |       |   |                    |        |                   |   |                |        |              |   |         |        |  |   |        
|                               | Core technology        |       |   | 3,853              |        |                   |   | (1,919         | )      |              |   | 3,853   |        |  |   | (1,557  | )     
|                               | Developed technology   |       |   | 16,857             |        |                   |   | (4,960         | )      |              |   | 17,808  |        |  |   | (2,487  | )     
|                               | Work force             |       |   | 215                |        |                   |   | (143           | )      |              |   | 215     |        |  |   | (116    | )     
|                               | Customer relationships |       |   | 2,490              |        |                   |   | (1,008         | )      |              |   | 2,490   |        |  |   | (484    | )     
|                               |                        |       |   |                    |        |                   |   |                |        |              |   |         |        |  |   |        
|                               |                        | Total |   | $                  | 23,414 |                   |   | $              | (8,030 | )            |   | $       | 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 is as follows (in thousands):

|                       |       |   |                    |       |                   |   |        |        |      |   |       |       |  |   |        |        | 
|---------------------- | ----- | - | ------------------ | ----- | ----------------- | - | ------ | ------ | ---- | - | ----- | ----- |  | - | ------ | ------ | 
|                       |       |   | Three months ended |       | Nine months ended
|                       |       |   | September 30,      |       | September 30,    
|                       |       |   | 2002               |       | 2001              |   | 2002   |        | 2001
|                       |       |   |                    |       |                   |   |        |        |     
|Goodwill               |       | $ |                   |       |                   | $ | 11,393 |        |      | $ |      |       |  | $ | 15,597 |       
|Core technology        |       |   | 120                |       |                   |   | 120    |        |      |   | 361   |       |  |   | 361    |       
|Developed technology   |       |   | 792                |       |                   |   | 967    |        |      |   | 2,474 |       |  |   | 1,278  |       
|Work force             |       |   | 9                  |       |                   |   | 9      |        |      |   | 27    |       |  |   | 27     |       
|Customer relationships |       |   | 207                |       |                   |   | 208    |        |      |   | 524   |       |  |   | 277    |       
|                       |       |   |                    |       |                   |   |        |        |      |   |       |       |  |   |        |       
|                       | Total |   | $                  | 1,128 |                   |   | $      | 12,697 |      |   | $     | 3,386 |  |   | $      | 17,540 | 
|                       |       |   |                    |       |                   |   |        |        |      |   |       |       |  |   |        |       

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

|             |                               |   |        |       | 
|------------ | ----------------------------- | - | ------ | ----- | 
|             |                               |   | Amount
|             |                               |   |       
|Fiscal year: |                               |   |        |      
|             | 2002 (remaining three months) |   | $      | 1,129 | 
|             | 2003                          |   |        | 4,483 | 
|             | 2004                          |   |        | 4,096 | 
|             | 2005                          |   |        | 3,888 | 
|             | 2006                          |   |        | 1,788 | 
|             |                               |   |        |      
|Total        |                               | $ | 15,384 |      
|             |                               |   |        |      

7



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##### 



INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

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 |   | Nine months ended
|                                                 |                          |   | September 30,      |   | September 30,    
|                                                 |                          |   |                    |   |                  
|                                                 |                          |   | 2002               |   | 2001              |   | 2002   |        | 2001
|                                                 |                          |   |                    |   |                   |   |        |        |     
|Net income (loss), reported                      |                          | $ | 6,341              |   |                   | $ | (6,088 | )      |      | $ | 13,835 |   |  | $ | (5,157 | )     
|                                                 | Amortization of goodwill |   |                    |  |                   |   |        | 11,393 |      |   |        |  |  |   |        | 15,597 | 
|                                                 |                          |   |                    |   |                   |   |        |        |      |   |        |   |  |   |        |       
|Net income, as adjusted                          |                          |   | 6,341              |   |                   |   | 5,305  |        |      |   | 13,835 |   |  |   | 10,440 |       
|                                                 |                          |   |                    |   |                   |   |        |        |      |   |        |   |  |   |        |       
|Basic net income (loss) per share,
as reported   |                          | $ | 0.13               |   |                   | $ | (0.13  | )      |      | $ | 0.29   |   |  | $ | (0.12  | )     
|Amortization of goodwill                         |                          |   |                   |   |                   |   | 0.24   |        |      |   |       |   |  |   | 0.35   |       
|                                                 |                          |   |                    |   |                   |   |        |        |      |   |        |   |  |   |        |       
|Basic net income per share,
as adjusted          |                          | $ | 0.13               |   |                   | $ | 0.11   |        |      | $ | 0.29   |   |  | $ | 0.23   |       
|                                                 |                          |   |                    |   |                   |   |        |        |      |   |        |   |  |   |        |       
|Diluted net income (loss) per
share, as reported |                          | $ | 0.13               |   |                   | $ | (0.13  | )      |      | $ | 0.28   |   |  | $ | (0.12  | )     
|                                                 | Amortization of goodwill |   |                    |  |                   |   |        | 0.24   |      |   |        |  |  |   |        | 0.35   | 
|                                                 |                          |   |                    |   |                   |   |        |        |      |   |        |   |  |   |        |       
|Diluted net income per share,
as adjusted        |                          | $ | 0.13               |   |                   | $ | 0.11   |        |      | $ | 0.28   |   |  | $ | 0.23   |       
|                                                 |                          |   |                    |   |                   |   |        |        |      |   |        |   |  |   |        |       

Outstanding options to purchase 881,000 and 1,344,000 shares of the
Companys common stock were not included in the computation of diluted net
income (loss) per share in the three months and nine months ended September 30,
2001, respectively, as their impact on loss per share is antidilutive.

5.  Comprehensive income (loss)

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

|                                            |  |                    |       |                   |  |      |        |      |  |   |        |  |  |   |        |  
|------------------------------------------- |  | ------------------ | ----- | ----------------- |  | ---- | ------ | ---- |  | - | ------ |  |  | - | ------ | -
|                                            |  | Three months ended |       | Nine months ended
|                                            |  | September 30,      |       | September 30,    
|                                            |  |                    |       |                  
|                                            |  | 2002               |       | 2001              |  | 2002 |        | 2001
|                                            |  |                    |       |                   |  |      |        |     
|Net income (loss)                           |  | $                  | 6,341 |                   |  | $    | (6,088 | )    |  | $ | 13,835 |  |  | $ | (5,157 | )
|Change in cumulative
translation adjustment |  |                    | (903  | )                 |  |      | 1,074  |      |  |   | 1,506  |  |  |   | 678    |  
|                                            |  |                    |       |                   |  |      |        |      |  |   |        |  |  |   |        |  
|Comprehensive income (loss)                 |  | $                  | 5,438 |                   |  | $    | (5,014 | )    |  | $ | 15,341 |  |  | $ | (4,479 | )
|                                            |  |                    |       |                   |  |      |        |      |  |   |        |  |  |   |        |  

6.      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 |  | Nine months ended
|                                     |                                                                        |   |      | September 30,      |  | September 30,    
|                                     |                                                                        |   |      |                    |  |                  
|                                     |                                                                        |   |      | 2002               |  | 2001              |       | 2002   |   | 2001
|                                     |                                                                        |   |      |                    |  |                   |       |        |   |     
|Basic net income (loss) per share:   |                                                                        |   |      |                    |  |                   |       |        |   |      |      |        |  |   |       |       
|                                     | Net income (loss)                                                      |   | $    | 6,341              |  |                   | $     | (6,088 | ) |      | $    | 13,835 |  |   | $     | (5,157 | )
|                                     | Weighted average number of common
shares outstanding during the period |   |      | 48,393             |  |                   |       | 47,693 |   |      |      | 48,080 |  |   |       | 44,764 |  
|                                     |                                                                        |   |      |                    |  |                   |       |        |   |      |      |        |  |   |       |       
|Basic net income (loss) per share    |                                                                        | $ | 0.13 |                    |  | $                 | (0.13 | )      |   | $    | 0.29 |        |  | $ | (0.12 | )     
|                                     |                                                                        |   |      |                    |  |                   |       |        |   |      |      |        |  |   |       |       
|Diluted net income (loss) per share: |                                                                        |   |      |                    |  |                   |       |        |   |      |      |        |  |   |       |       
|                                     | Net income (loss)                                                      |   | $    | 6,341              |  |                   | $     | (6,088 | ) |      | $    | 13,835 |  |   | $     | (5,157 | )
|                                     | Weighted average number of common                                      |   |      |                    |  |                   |       |        |   |      |      |        |  |   |       |        |  

8



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##### 



INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

| |                                                                             |                                      |   |                    |        |                   |   |        |        |      |   |        |        |  |   |        |        | 
| | --------------------------------------------------------------------------- | ------------------------------------ | - | ------------------ | ------ | ----------------- | - | ------ | ------ | ---- | - | ------ | ------ |  | - | ------ | ------ | 
| |                                                                             |                                      |   | Three months ended |        | Nine months ended
| |                                                                             |                                      |   | September 30,      |        | September 30,    
| |                                                                             |                                      |   |                    |        |                  
| |                                                                             |                                      |   | 2002               |        | 2001              |   | 2002   |        | 2001
| |                                                                             |                                      |   |                    |        |                   |   |        |        |     
| |                                                                             | shares outstanding during the period |   |                    | 48,393 |                   |   |        | 47,693 |      |   |        | 48,080 |  |   |        | 44,764 | 
| | Dilutive stock options                                                      |                                      |   | 462                |        |                   |   |       |        |      |   | 785    |        |  |   |       |       
| |                                                                             |                                      |   |                    |        |                   |   |        |        |      |   |        |        |  |   |       
| | Total shares for purpose of
calculating diluted net income (loss)
per share |                                      |   | 48,855             |        |                   |   | 47,693 |        |      |   | 48,865 |        |  |   | 44,764 |       
| |                                                                             |                                      |   |                    |        |                   |   |        |        |      |   |        |        |  |   |       
| | Diluted net income (loss) per share                                         |                                      | $ | 0.13               |        |                   | $ | (0.13  | )      |      | $ | 0.28   |        |  | $ | (0.12  | )     
| |                                                                             |                                      |   |                    |        |                   |   |        |        |      |   |        |        |  |   |       

7.  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 (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 September 30, 2002 |       |             |       |       |       |          |         |      |   | Three months ended September 30, 2001 |        |             |        |      
|                                  |                                         |                            |        |          |       
|                                  |                                         |                            |        | Americas |        | EMEA |       | Asia/Pacific                          |       | Unallocated |       | Total |       | Americas |         | EMEA |   | Asia/Pacific                          |        | Unallocated |        | Total
|                                  |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |      
|Revenues from external
customers: |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |       |        |       |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|                                  |                                         | Product licenses
and sales |        | $        | 20,513 |      |       | $                                     | 4,174 |             |       | $     | 5,463 |          |         | $    |  |                                       |        | $           | 30,150 |       |        | $     | 17,325 |   |       | $     | 4,541 |   |       | $     | 5,569 |   |         | $ |  |   |         | $      | 27,435 | 
|                                  |                                         | Subscriptions              |        |          | 18,494 |      |       |                                       | 3,325 |             |       |       | 2,334 |          |         |      |  |                                       |        |             | 24,153 |       |        |       | 14,597 |   |       |       | 1,754 |   |       |       | 1,312 |   |         |   |  |   |         |        | 17,663 | 
|                                  |                                         | Professional services      |        |          | 5,203  |      |       |                                       | 1,158 |             |       |       | 1,104 |          |         |      |  |                                       |        |             | 7,465  |       |        |       | 5,381  |   |       |       | 1,637 |   |       |       | 618   |   |         |   |  |   |         |        | 7,636  | 
|                                  |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |       |        |       |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|Total revenue                     |                                         |                            | 44,210 |          |        |      | 8,657 |                                       |       |             | 8,901 |       |       |          |        |      |   |                                       | 61,768 |             |        |       | 37,303 |       |        |   | 7,932 |       |       |   | 7,499 |       |       |   |        |   |   |   | 52,734  |       
|Cost of revenues:                 |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |       |        |       |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|                                  | Product licenses and sales              |                            |        | 1,915    |        |      |       |                                      |       |             |       | 13    |       |          |         |     |   |                                       |        | 1,928       |        |       |        | 1,399 |        |   |       | 2     |       |   |       |      |       |   |         |  |   |   |         | 1,401  |       
|                                  | Subscriptions and professional
services |                            |        | 8,571    |        |      |       | 2,046                                 |       |             |       | 2,149 |       |          |         |     |   |                                       |        | 12,766      |        |       |        | 9,215 |        |   |       | 1,897 |       |   |       | 1,676 |       |   |         |  |   |   |         | 12,788 |       
|                                  |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |       |        |       |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|Total cost of revenues            |                                         |                            | 10,486 |          |        |      | 2,046 |                                       |       |             | 2,162 |       |       |          |        |      |   |                                       | 14,694 |             |        |       | 10,614 |       |        |   | 1,899 |       |       |   | 1,676 |       |       |   |        |   |   |   | 14,189  |       
|Operating expenses                |                                         |                            | 15,847 |          |        |      | 5,502 |                                       |       |             | 2,431 |       |       |          | 15,936  |      |   |                                       | 39,716 |             |        |       | 14,882 |       |        |   | 6,287 |       |       |   | 2,280 |       |       |   | 28,391  |   |   |   | 51,840  |       
|                                  |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |       |        |       |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       
|Total expenses                    |                                         |                            | 26,333 |          |        |      | 7,548 |                                       |       |             | 4,593 |       |       |          | 15,936  |      |   |                                       | 54,410 |             |        |       | 25,496 |       |        |   | 8,186 |       |       |   | 3,956 |       |       |   | 28,391  |   |   |   | 66,029  |       
|Segment operating income (loss)   |                                         | $                          | 17,877 |          |        | $    | 1,109 |                                       |       | $           | 4,308 |       |       | $        | (15,936 | )    |   | $                                     | 7,358  |             |        | $     | 11,807 |       |        | $ | (254  | )     |       | $ | 3,543 |       |       | $ | (28,391 | ) |   | $ | (13,295 | )     
|                                  |                                         |                            |        |          |        |      |       |                                       |       |             |       |       |       |          |         |      |   |                                       |        |             |        |       |        |       |        |   |       |       |       |   |       |       |       |   |         |   |   |   |         |       

|                                  |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |        |        | 
|--------------------------------- | --------------------------------------- | -------------------------- | ------- | ------------------------------------ | ------ | ---- | ------ | ------------ | ------ | ----------- | ------ | ----- | ------------------------------------ | -------- | ------- | - | - | - | ------- | ------ | ------ | ------------ | ------- | ----------- | ------ | ----- |  |  |  | - | ------ | ----- | ------ | - | ------ | ----- | ------ | - | ------- | - | - | - | ------- | ------ | ------ | 
|                                  |                                         |                            |         | Nine months ended September 30, 2002 |        |      |        |              |        |             |        |       | Nine months ended September 30, 2001
|                                  |                                         |                            |         |                                      |       
|                                  |                                         |                            |         | Americas                             |        | EMEA |        | Asia/Pacific |        | Unallocated |        | Total |                                      | Americas |         |   |   |   | EMEA    |        |        | Asia/Pacific |         | Unallocated |        | Total
|                                  |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |      
|Revenues from external
customers: |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |       
|                                  |                                         | Product licenses and sales |         | $                                    | 61,635 |      |        | $            | 13,038 |             |        | $     | 15,877                               |          |         | $ |  |   |         | $      | 90,550 |              |         | $           | 61,838 |       |  |  |  |   |        | $     | 13,535 |   |        | $     | 16,326 |   |         | $ |   |   |         | $      | 91,699 | 
|                                  |                                         | Subscriptions              |         |                                      | 51,918 |      |        |              | 9,007  |             |        |       | 6,338                                |          |         |   |  |   |         |        | 67,263 |              |         |             | 38,915 |       |  |  |  |   |        |       | 5,893  |   |        |       | 3,451  |   |         |   |  |   |         |        | 48,259 | 
|                                  |                                         | Professional services      |         |                                      | 15,063 |      |        |              | 3,959  |             |        |       | 3,341                                |          |         |   |  |   |         |        | 22,363 |              |         |             | 18,186 |       |  |  |  |   |        |       | 5,325  |   |        |       | 2,130  |   |         |   |  |   |         |        | 25,641 | 
|                                  |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |       
|Total revenue                     |                                         |                            | 128,616 |                                      |        |      | 26,004 |              |        |             | 25,556 |       |                                      |          |        |   |   |   | 180,176 |        |        |              | 118,939 |             |        |       |  |  |  |   | 24,753 |       |        |   | 21,907 |       |        |   |        |   |   |   | 165,599 |       
|Cost of revenues:                 |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |       
|                                  | Product licenses and sales              |                            |         | 5,544                                |        |      |        |             |        |             |        | 55    |                                      |          |         |  |   |   |         | 5,599  |        |              |         | 11,288      |        |       |  |  |  |   |        | 254   |        |   |        | 10    |        |   |         |  |   |   |         | 11,552 |       
|                                  | Subscriptions and professional
services |                            |         | 26,200                               |        |      |        | 6,407        |        |             |        | 6,030 |                                      |          |         |  |   |   |         | 38,637 |        |              |         | 28,545      |        |       |  |  |  |   |        | 5,515 |        |   |        | 4,023 |        |   |         |  |   |   |         | 38,083 |       
|                                  |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |       
|Total cost of revenues            |                                         |                            | 31,744  |                                      |        |      | 6,407  |              |        |             | 6,085  |       |                                      |          |        |   |   |   | 44,236  |        |        |              | 39,833  |             |        |       |  |  |  |   | 5,769  |       |        |   | 4,033  |       |        |   |        |   |   |   | 49,635  |       
|Operating expenses                |                                         |                            | 49,053  |                                      |        |      | 14,664 |              |        |             | 6,652  |       |                                      |          | 48,600  |   |   |   | 118,969 |        |        |              | 45,326  |             |        |       |  |  |  |   | 16,574 |       |        |   | 7,096  |       |        |   | 64,666  |   |   |   | 133,662 |       
|                                  |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |       
|Total expenses                    |                                         |                            | 80,797  |                                      |        |      | 21,071 |              |        |             | 12,737 |       |                                      |          | 48,600  |   |   |   | 163,205 |        |        |              | 85,159  |             |        |       |  |  |  |   | 22,343 |       |        |   | 11,129 |       |        |   | 64,666  |   |   |   | 183,297 |       
|Segment operating income (loss)   |                                         | $                          | 47,819  |                                      |        | $    | 4,933  |              |        | $           | 12,819 |       |                                      | $        | (48,600 | ) |   | $ | 16,971  |        |        | $            | 33,780  |             |        |       |  |  |  | $ | 2,410  |       |        | $ | 10,778 |       |        | $ | (64,666 | ) |   | $ | (17,698 | )     
|                                  |                                         |                            |         |                                      |        |      |        |              |        |             |        |       |                                      |          |         |   |   |   |         |        |        |              |         |             |        |       |  |  |  |   |        |       |        |   |        |       |        |   |         |   |   |   |         |       

9



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##### 



INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIALS - (Continued)

8.  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 $200.5 million as of September 30, 2002 was
recorded in June 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 144 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.

9.  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. Six
such actions were filed in the United States District Court for the Northern
District of Georgia. All six actions have been consolidated into a single case
and the court has appointed lead plaintiffs and lead plaintiffs counsel. The
consolidated amended complaint was filed October 9, 2002 and purports 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
complaint generally alleges 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 complaint seeks damages in an unspecified amount.
The Companys response to the consolidated amended complaint is
currently due by November 25, 2002. The
Company believes that it has meritorious defenses and intends to defend the
actions vigorously.

10. Subsequent event

On October 31, 2002, the Company completed the acquisition of privately
held vCIS, Inc. of Santa Clara, California, the developer of patent-pending,
next-generation, pre-emptive behavioral inspection technology. The technology
prevents malicious code from executing and causing damage before it has an
opportunity to interact with the enterprise network. The integrated pre-emptive
behavioral technology is expected to be available for the desktop in the first
quarter of 2003. Each outstanding share of vCIS common stock, no par value, was
converted into the right to receive .04770 shares of ISS common stock, par
value $0.001 per share. Additionally, each outstanding stock option to purchase shares of vCIS
common stock was assumed by ISS and converted into a stock option to purchase shares
of ISS Common Stock. ISS will issue an aggregate of approximately 1,000,000
shares of ISS Common Stock for the outstanding vCIS common stock and
stock options
assumed. Shares will be reserved for future exercise of stock options
outstanding under the vCIS stock option plan assumed in the transaction. An
in-process research and development charge is expected to be incurred in the
fourth quarter of 2002 in accounting for this transaction. This charge may represent a
significant portion of the total combined fair value of the common
stock issued, stock options assumed and estimated acquisition costs of approximately
$19.2 million.

10



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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 current intent, belief or 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 the SECs 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, focusing on security assessment
and intrusion detection systems, and also including 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:



| |  |  | persuasive evidence of an arrangement exists;        
| | - |  | -----------------------------------------------------
|
| |  |  | delivery has occurred or services have been rendered;

11



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##### 



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



| |  |  | price is fixed or 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 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 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 sold 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 nine-months 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,
with customers 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. To date, 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 is reevaluated and
adjusted as additional information is received.

12



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##### 



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

Our provisions for
doubtful accounts during the three months ended September 30,
2002 and for the nine months ended September 30, 2002 amounted
to $410,000 and
$1,075,000, respectively. At December 31, 2001, our allowance for doubtful
accounts included approximately $400,000 that had been reserved specifically
for two customers. Because the amounts due from these customers were successfully collected in 2002, the
allowance was decreased accordingly. During the first nine months of 2002, in
response to the difficult current economic conditions, we wrote off
approximately $626,000 of receivables that were deemed uncollectible due to the
deteriorating condition of certain customers. Our September 30, 2002 allowance
for doubtful accounts totals 4.0% of the $65.7 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
$200 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
nine months ended September 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 |     | Nine months ended
|                                                               |                          |  | September 30,      |     | September 30,    
|                                                               |                          |  |                    |     |                  
|                                                               |                          |  | 2002               |     | 2001              |  | 2002 |     | 2001
|                                                               |                          |  |                    |     |                   |  |      |     |     
|Product licenses and sales                                     |                          |  | 49                 | %   |                   |  | 52   | %   |      |  | 50 | %   |   |  | 55  | %  
|Subscriptions                                                  |                          |  | 39                 | %   |                   |  | 34   | %   |      |  | 37 | %   |   |  | 29  | %  
|Professional services                                          |                          |  | 12                 | %   |                   |  | 14   | %   |      |  | 13 | %   |   |  | 16  | %  
|                                                               |                          |  |                    |     |                   |  |      |     |      |  |    |     |   |  |     |    
|                                                               | Total revenues           |  |                    | 100 | %                 |  |      | 100 | %    |  |    | 100 | % |  |     | 100 | %
|                                                               |                          |  |                    |     |                   |  |      |     |      |  |    |     |   |  |     |    
|Cost of product revenues                                       |                          |  | 3                  | %   |                   |  | 3    | %   |      |  | 3  | %   |   |  | 7   | %  
|Cost of subscription and
professional service revenues         |                          |  | 21                 | %   |                   |  | 24   | %   |      |  | 22 | %   |   |  | 23  | %  
|Research and development                                       |                          |  | 14                 | %   |                   |  | 18   | %   |      |  | 14 | %   |   |  | 16  | %  
|Sales and marketing                                            |                          |  | 38                 | %   |                   |  | 44   | %   |      |  | 39 | %   |   |  | 42  | %  
|General and administrative                                     |                          |  | 10                 | %   |                   |  | 10   | %   |      |  | 10 | %   |   |  | 9   | %  
|Write-off of lease obligation                                  |                          |  |                   |     |                   |  |     |     |      |  |   |     |   |  | 1   | %  
|Charge for in-process research and
development                 |                          |  |                   |     |                   |  |     |     |      |  |   |     |   |  | 2   | %  
|Amortization of goodwill                                       |                          |  |                   |     |                   |  | 22   | %   |      |  |   |     |   |  | 9   | %  
|Amortization of other intangibles
and stock-based compensation |                          |  | 2                  | %   |                   |  | 4    | %   |      |  | 2  | %   |   |  | 2   | %  
|                                                               |                          |  |                    |     |                   |  |      |     |      |  |    |     |   |  |     |    
|                                                               | Total costs and expenses |  |                    | 88  | %                 |  |      | 125 | %    |  |    | 90  | % |  |     | 111 | %
|                                                               |                          |  |                    |     |                   |  |      |     |      |  |    |     |   |  |     |    
|Operating income (loss)                                        |                          |  | 12                 | %   |                   |  | (25  | )%  |      |  | 10 | %   |   |  | (11 | )% 
|                                                               |                          |  |                    |     |                   |  |      |     |      |  |    |     |   |  |     |    

13



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##### 



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

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 49% of total revenues for the three-month period ended
September 30, 2002 and 52% for the corresponding period in 2001. Product
licenses and sales represented 50% of total revenues for the nine-month period
ended September 30, 2002, as compared to 55% for the same period in 2001. The
decrease in product licenses and sales as a percentage of total revenues from
2001 to 2002 is due to the decrease in the sales of third-party products.

We continue sales of third-party products as part of our managed security
services offerings, otherwise de-emphasizing the direct sales of third-party
products. As a result, third-party product revenues decreased from 4% of total
revenues in the quarter ended September 30, 2001 to 3% in the corresponding
period of 2002. On a year-to-date basis, third-party product revenues
decreased as a percentage of total revenues from 10% in 2001 to 3% in 2002.

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.

Subscriptions

Subscription revenues consist of maintenance, term licenses of product
usage and security-monitoring fees for managed services offerings.
Subscriptions revenue represented 39% of total revenues in the three months
ended September 30, 2002 increasing from 34% of total revenues in the three
months ended September 30, 2001. Maintenance continues to represent the largest
portion of our subscription revenue, accounting for 27% of total revenues in
the three months ended September 30, 2002 and 23% 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.

Monitoring fees represented 8% of total revenues in the third quarter of
2002, a one-percentage point increase over the corresponding period of 2001.
We continue to focus on our intrusion protection offerings, which resulted in a
6% increase in monitoring revenues in the third quarter of 2002 as compared to the second quarter of
2002.

On a year-to-date basis, subscriptions revenue represented 37% of total
revenues in the nine months ended September 30, 2002, as compared to 29% in the
nine months ended September 30, 2001. The year-to-date increase is primarily
the result of increased maintenance. Security-monitoring fees increased 19% in
the first nine months of 2002 compared with 2001 despite decreasing 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. In addition, we have had
some customers bring firewall management in-house. As a result,
management of our products is a larger portion of our managed services business
which we perceive as providing long-term value to our customers.

Professional services

Professional services revenue represented 12% of total revenues in the
three months ended September 30, 2002, decreasing from 13% in the corresponding
period of 2001. For the nine months ended September 30, 2002, professional
services revenue was 13% of revenue, which was a decrease from 16% in the
corresponding period of 2001. During 2002, professional services as a
percentage of total revenues decreased partially due to continued customer
reluctance to spend discretionary dollars on professional services. Also
contributing to this decline was a narrowing of our consulting offerings to
focus on high-value offerings that utilize our X-Force

14



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##### 



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

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 |    | Nine months ended
|                 |  | September 30,      |    | September 30,    
|                 |  |                    |    |                  
|                 |  | 2002               |    | 2001              |  | 2002 |    | 2001
|                 |  |                    |    |                   |  |      |    |     
|Americas         |  |                    | 72 | %                 |  |      | 71 | %    |  |  | 71 | % |  |  | 72 | %
|EMEA             |  |                    | 14 | %                 |  |      | 15 | %    |  |  | 15 | % |  |  | 15 | %
|Asia/Pacific Rim |  |                    | 14 | %                 |  |      | 14 | %    |  |  | 14 | % |  |  | 13 | %

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. We experienced
lower margins on these sales in the third quarter of 2002 compared to 2001. As
a result, costs of product revenues as a percentage of total revenues remained
constant at 3% for the three months ended September 30, 2002 and
2001, even
though third party revenues declined.

On a year-to-date basis, cost of product revenues decreased from 7% of
total revenues for the nine months ended September 30, 2001 to 3% for the nine
months ended September 30, 2002, as sales of partner software and hardware
appliances represented a lower percentage of total revenues. This decrease was
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 24% of total revenues in the three
months ended September 30, 2001 to 21% of total revenues in the three months
ended September 30, 2002. A similar trend existed on a year-to-date basis as
these costs decreased from 23% of total revenues for the nine months
ended September 30, 2001 to 22% in 2002.

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 revenues. 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 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

15



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##### 



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

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. In the third quarter of 2002, we continued the release of major
enhancements to our product lines. After releasing RealSecure Network Protector
7.0 and RealSecure Server Sensor 3.5 in the second quarter, we released
RealSecure Desktop Protector 3.5 in the third quarter, which added improved
scalability and the ability to block outbound network traffic as well as new
protection from malicious application execution. We also provided enhancements
to our management consoles and our vulnerability assessment products as well as
RealSecure Guard, RealSecure Sentry, and RealSecure Gigabit Sentry.

Research and development expenses were 14% of total revenues in the three
months ended September 30, 2002, compared to 18% in the comparable period of
2001 as we have been able to provide new product offerings and enhancements
with fewer headcount. An example of this efficiency is our protocol analysis
framework that allows us to gain engineering efficiency as it requires fewer
signature updates than traditional IDS software. On a year-to-date basis these
costs represented 14% of total revenues in 2002, a decrease from 16% of total
revenues in the comparable period of 2001.

While we are committed to continue our investment in X-Force research
capabilities that we believe to be a differentiator for ISS, we
intend to continue to seek
more leverage in the research and development area while enhancing current
technologies and developing 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.

Gaining leverage in sales and marketing is a key objective for us. This is
evidenced by the decrease in these expenses as a percentage of total revenues
from 44% in the three months ended September 30, 2001 to 38% in the comparable
period of 2002. For the nine-month periods ended September 30, these expenses
decreased as a percentage of revenues from 42% in 2001 to 39% in 2002. We have
undertaken several initiatives over the last year to achieve this
decrease.
During the third quarter of 2001 we resized our operations, resulting in
personnel reductions and decreases in various operating expenses. As a result,
the 2001 periods included costs of severance associated with the personnel
reductions. In areas where revenue demand did not support our cost base, such
as Latin America and Europe, we reduced headcount in the third quarter of 2002.
We also continue to achieve leverage 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. Although we
decreased our sales and marketing expenses as a percentage of total
revenues, we did increase our advertising costs. Beginning in the first quarter of
2002, and completed in 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 was 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 continue 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 $5.9 million in the third quarter
of 2002 and $5.5 million in the third quarter of 2001 represented approximately
10% of total revenues in both 2002 and 2001. On a year-to-date basis, general
and administrative expenses increased from 9% of total revenues in 2001 to 10%
in 2002. This year-to-date increase in 2002 related to non-recurring expenses
associated with a relocation of our Asia/Pacific headquarters in Tokyo during
the second quarter of 2002. Excluding these non-recurring charges, general and
administrative expenses remained at 9% of total revenue in the three months
ended September 30, 2002 compared to the same period of 2001.

16



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##### 



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

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.

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

Operating expenses for the nine-month period ended September 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 nine months ended September 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 $1.3 million and $13.6 million in the
three months ended September 30, 2002 and 2001, respectively. Amortization
expense for the nine-month periods ended September 30, 2002 and 2001 was $4.3
million and $19.0 million, respectively. These decreases were due to the
adoption of SFAS No. 142 on January 1, 2002, under which the carrying values of
goodwill and intangible assets deemed to have indefinite lives are no longer
amortized, but are subject to an annual impairment test. In 2002, amortization
relates to intangible assets and stock-based compensation, resulting from
acquisitions accounted for under the purchase method.

Interest income

The market rate of interest paid on investment-quality commercial paper
and similar investments dropped from approximately 4.4% during the third
quarter of 2001 to approximately 2.0% in the third quarter of 2002. As a
result, interest income decreased despite an increase in total cash and cash
equivalents and interest-bearing marketable securities. Specifically, net
interest income decreased from $1.5 million in the quarter ended September 30,
2001 to $877,000 in the comparable quarter of 2002, and from $5.3 million in
the nine-months ended September 30, 2001 to $2.5 million in the corresponding
period of 2002.

Minority interest

Minority interest totaled $66,000 in the three months ended September 30,
2002 and $273,000 in the nine months ended September 30, 2002. Minority
interest expense for the three months and nine months ended September 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.

Other income

Other income for the third quarter of 2002 includes a $2.6 million gain
related to the issuance of subsidiary shares in the acquisition of a Singapore
company by our Asia-Pacific subsidiary. The gain represents the difference between
the fair market value of the shares issued in the acquisition and the book
value of those shares.

In the nine months ended September 30, 2002, other income also consists of
a second quarter gain of $1.9 million 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.

Pretax income for the three and nine months ended September 30, 2001
includes a subsidiary IPO gain of $13.6 million from an initial public offering
on the Japan over-the-counter market by the Companys subsidiary responsible
for Asia and Pacific Rim operations. Proceeds of the IPO were retained by the
subsidiary.

17



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##### 



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

Also included in pretax income in the nine months ended September 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.

Foreign currency exchange loss

Foreign currency
transactions resulted in the exchange gain of $145,000 and $68,000 in the three months and nine
months ended September 30, 2002, respectively, and the exchange loss of
$163,000 and $445,000 in the three months and nine months ended September 30,
2001, respectively.

Provision for (benefit from) income taxes

The effective tax rate was 39% and 40% for the three and nine months ended
September 30, 2002, respectively. For the comparable periods of 2001 the
provision for income taxes was approximately 500% of pre-tax loss for the three
months ended September 30, 2001 and 330% of pre-tax loss for the nine month
ended September 30, 2001. As a result of the acquisition of Network ICE during
the second quarter of 2001, we expensed approximately $26.3 million of goodwill
amortization that was not deductible for income tax purposes.

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 September 30, 2002, we estimated the annual effective income tax
rate for the calendar year 2002 to be 39%.

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 third
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 nine months of 2002 was $21.6
million and included net income of $13.8 million, non-cash depreciation and
amortization expense charges of $15.1 million, income tax benefit from employee
exercises of stock options of $7.0 million and growth in deferred revenues of
$5.5 million. These sources of cash were partially offset by a reduction in net
assets and liabilities, excluding cash, of $17.7 million.

Investing activities
in the first nine months of 2002 included the
purchase of $63.2 million of marketable securities, primarily commercial paper,
offset by net proceeds from the maturity of marketable securities of $63.3
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 $9.2 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 $3.0 million of cash in the nine months
ended September 30, 2002. Our financing activities 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, and the use of cash to
repurchase 130,000 of our common stock. In July of 2002 we
announced our plan to repurchase up to $50 million of our common stock over the
next twelve months utilizing cash on hand and cash flow generated from
operations. In the third quarter of 2002 we purchased 130,000 shares of our
common stock on the open market at a cost of $2.0 million.

18



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##### 



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

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 $13.3 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

As of September 30, 2002, we had $178.5 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. From time
to time we evaluate possible acquisition and investment opportunities in
businesses, products and 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.

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. With respect to our Business
Outlook published in our earnings press release each quarter, the public can
continue to rely on the revenue and earnings expectations prior to the start of
our quiet period unless we have published a notice stating
otherwise. Toward the end of each quarter, we have a quiet period when we
will not comment concerning the previously published financial expectations,
and we disclaim any obligation to update during the quiet period. The public
should not rely on previously published expectations during the quiet period.
The quiet period runs from the 15th of the last month of the quarter until
our earnings release during the first month of the following quarter. We
otherwise 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;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

19



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##### 



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



| |  |  | 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 requires substantial 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 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 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.                                                                                                                                                                 

20



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

Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, such as Symantecs acquisition of
Recourse Technologies and Riptech Inc., completed in the third quarter of 2002,
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.

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

21



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

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.    

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 17
patent applications under review. We also believe that the technological and
creative skills of our personnel, new product developments, frequent product
enhancements, our name

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

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.

23



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##### 



|         |  |                                                           
|-------- |  | ----------------------------------------------------------
|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 September 30, 2002 mature as follows: $16.9 million within three
months, $24.9 million in three to six months and $12.9 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.

|        |  |                        
|------- |  | -----------------------
|ITEM 4. |  | CONTROLS AND PROCEDURES

As required by SEC rules, we have evaluated the effectiveness of the
design and operation of our disclosure controls and procedures within 90 days
of the filing of this quarterly report. This evaluation was carried out under
the supervision and with the participation of our management, including our
principal executive officer and principal financial officer. Based on this
evaluation, these officers have concluded that the design and operation of our
disclosure controls and procedures are effective. There were no significant
changes to our internal controls or in other factors that could significantly
affect disclosure controls subsequent to the date of their evaluation.

Disclosure controls and procedures are our controls and other procedures
that are designed to ensure that information required to be disclosed by us in
the reports that we file or submit under the Securities Exchange Act
of 1934 is recorded,
processed, summarized and reported, within the time periods specified in the
SECs rules and forms. Disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information
required to be disclosed by us in the reports that we file under the Exchange
Act is accumulated and communicated to our management, including principal
executive officer and principal financial officer, as appropriate, to allow
timely decisions regarding required disclosure.

|        |  |                  
|------- |  | -----------------
|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. Six
such actions were filed in the United States District Court for the Northern
District of Georgia. All six actions have been consolidated into a single case
and the court has appointed lead plaintiffs and lead plaintiffs counsel. The
consolidated complaint was filed October 9, 2002 and purports 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
complaint generally alleges 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 complaint seeks damages in an unspecified amount.

24



---



##### 



The Companys response to the consolidated
amended complaint is currently due by November 25, 2002. The Company believes
that it has meritorious defenses and intends to defend the actions vigorously.

25



---



##### 



|        |  |                                 
|------- |  | --------------------------------
|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 a report on Form 8-K on July 24, 2002 with respect to the adoption of a shareholder rights plan.



---

|* |  | Data required by SFAS
No. 128, Earnings Per Share, is provided in
note 6 to
the consolidated financial statements in this report.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------

26



---



##### 



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:  November 13,
2002 | By: |                                 | /s/ Richard Macchia                                               
|                         |     |                                 | Chief Financial Officer
Vice President and Chief Financial Officer
|                        
|                         |     |                                 | (Duly Authorized Officer and Principal Financial Officer)         
|                        
|                         | By: |                                 | /s/ Maureen Richards                                              
|                         |     |                                 | Corporate Controller
(Chief Accounting Officer)                   

27



---



##### 



CERTIFICATION

I, Thomas E. Noonan, certify that:



| |    |                                                                                       
| | -- | --------------------------------------------------------------------------------------
| | 1. | I have reviewed this quarterly
report on Form 10-Q of Internet
Security Systems, Inc.;



| |    |                                                                                                                                                                                                                                                                                                                               
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 2. | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;



| |    |                                                                                                                                                                                                                                                                                                            
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3. | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;



| |    |                                                                                                                                                                                                                          
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 4. | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;



| |                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | b) evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and



| |                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;



| |    |                                                                                                                                                                                                                                               
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. | The registrants other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrants auditors and
the audit committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and



| |                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| | b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal
controls; and



| |    |                                                                                                                                                                                                                                                                                                                                                                                          
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. | The registrants other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.

Date:
November 13, 2002

| |                                                                                      
| | -------------------------------------------------------------------------------------
| | /s/  Thomas E. NoonanThomas E. Noonan
Chairman, President and
Chief Executive Officer

28



---



##### 



CERTIFICATION

I, Richard Macchia, certify that:



| |    |                                                                                       
| | -- | --------------------------------------------------------------------------------------
| | 1. | I have reviewed this quarterly report on Form 10-Q of Internet
Security Systems, Inc.;



| |    |                                                                                                                                                                                                                                                                                                                               
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 2. | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;



| |    |                                                                                                                                                                                                                                                                                                            
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3. | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;



| |    |                                                                                                                                                                                                                          
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 4. | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:



| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;



| |                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | b) evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and



| |                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;



| |    |                                                                                                                                                                                                                                               
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. | The registrants other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrants auditors and
the audit committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and



| |                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| | b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal
controls; and



| |    |                                                                                                                                                                                                                                                                                                                                                                                          
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. | The registrants other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.

Date: November 13, 2002

| |                                                                               
| | ------------------------------------------------------------------------------
| | /s/  Richard MacchiaRichard Macchia
Vice President and
Chief Financial Officer

29