Conformed


UNITED STATES


SECURITIES AND EXCHANGE
COMMISSION


Washington,
D.C.  20549


FORM 10-K


(Mark
      One)[ X ]
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d)
              OF
      THE SECURITIES EXCHANGE ACT OF 1934
              For
      the fiscal year ended December 31, 2007OR[    ]
            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 0-26494





GSE Systems,
      Inc.(Exact
      name of registrant as specified in its charter)
  
 Delaware
              
              52-1868008(State
      of incorporation)
              
              (I.R.S.
      Employer Identification Number)7133 Rutherford Rd, Suite 200,
      Baltimore MD.
              
              21244(Address
      of principal executive offices)
              
              (Zip
      Code)


Registrant's
telephone number, including area code:  (410) 277-3740





SECURITIES
REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:





Title
      of each class
              
              Name
      of each exchange on which registeredCommon
      Stock, $.01 par value
              
              American
      Stock Exchange


SECURITIES
REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE


Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act. Yes
[  ]   No  [X]





Indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or 15(d) of
the Act. Yes [ ]    No [X]





Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days. Yes [ X ]
No [   ]





Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendment to this Form 10-K.
[  ]





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer.  See the definitions of
“large accelerated filer”, “accelerated filer” and “smaller reporting company”
in Rule 12b-2 of the Exchange Act.  (Check one):





Large
      accelerated filer  [  ]
            Accelerated
      filer  [ X ]
            Non-accelerated
      filer [ ]
            Smaller
      reporting company [ ](Do
      not check if a smaller reporting company)





Indicate
by check mark whether the registrant is a shell company (as defined in rule
12(b)-2 of the Exchange
Act).    Yes  [  ]  No
[X]





The aggregate market value of Common
Stock held by non-affiliates of the Registrant was $93,823,138 on June 29, 2007,
the last business day of the Registrant’s most recently completed second fiscal
quarter, based on the closing price of such stock on that date of
$6.60.





The
number of shares outstanding of the registrant’s Common Stock as of March 14,
2008 was 15,511,790 shares.








DOCUMENTS
INCORPORATED BY REFERENCE





Portions of the registrant's Proxy
Statement for the 2008 Annual Meeting of Stockholders to be filed pursuant to
Regulation 14A under the Securities Exchange Act of 1934, as amended, are
incorporated by reference into Part III.





GSE SYSTEMS, INC.




FORM
10-K





For the
Year Ended December 31, 2007








TABLE OF CONTENTS





PART I
            
            PageItem
      1.
            Business
            4Item
      1A.
            Risk
      Factors
            18Item
      1B.
            Unresolved
      Staff Comments
            23Item
      2.
            Properties
            23Item
      3.
            Legal
      Proceedings
            23Item
      4.
            Submission
      of  Matters to a Vote of Security Holders
            24PART IIItem
      5.
            Market
      for Registrant’s Common Equity,  Related
              Stockholder
      Matters, and Issuer Purchases of Equity Securities
            24Item
      6.
            Selected
      Consolidated Financial Data
            28Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition
              and
      Results of Operations
            30Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk
            49Item
      8.
            Financial
      Statements and Supplementary Data
            50Item
      9.
            Changes
      in and Disagreements with Accountants
              on
      Accounting and Financial Disclosure
            51Item
      9A.
            Controls
      and Procedures
            51Item
      9B.
            Other
      Information
            52PART IIIItem
      10.
            Directors
      and Executive Officers of the Registrant and Corporate Governance
      Matters*
            52Item
      11.
            Executive
      Compensation*
            52Item
      12.
            Security
      Ownership of Certain Beneficial Owners
              and
      Management and Related Stockholder Matters*
            53Item
      13.
            Certain
      Relationships and Related Transactions and Director
      Independence*
            53Item
      14.
            Principal
      Accountant Fees and Services*
            53PART IVItem
      15.
            Exhibits
      and Financial Statement Schedules.
            54SIGNATURES
            55Exhibits
      Index
            56





*
            to
      be incorporated by reference from the Proxy Statement for the registrant’s
      2008 Annual Meeting of
Shareholders.











2


CAUTIONARY
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS.





This
report and the documents incorporated by reference herein contain
“forward-looking” statements within the meaning of Section 27A of the Securities
Act and Section 21E of the Exchange Act that are
based on management’s assumptions, expectations and projections about us, and
the industry within which we operate, that have been made pursuant to the
Private Securities Litigation Reform Act of 1995 which reflect our expectations
regarding our future growth, results of operations, performance and business
prospects and opportunities.  Wherever possible, words such as
“anticipate”, “believe”, “continue”, “estimate”, “intend”, “may”, “plan”,
“potential”, “predict”, “expect”, “should”, “will” and similar expressions, or
the negative of these terms or other comparable terminology, have been used to
identify these forward-looking statements.  These forward-looking
statements may also use different
phrases.  These  statements regarding
our expectationsreflect our
current  beliefs  and  are  based  on  information  currently  available  to
us.  Accordingly, these statements by their nature are subject to
risks and uncertainties, including those listed under Item 1A Risk Factors,
which could cause our actual growth, results, performance and business prospects
and opportunities to differ from those expressed in, or implied by, these
statements. We may not actually achieve the plans, intentions or
expectations disclosed in our forward-looking statements and you should not
place undue reliance on our forward-looking statements. Actual results or events
could differ materially from the plans, intentions and expectations disclosed in
the forward-looking statements we make. Except as otherwise  required
by federal  securities  law,  we
are  not  obligated  to  update  or  revise  these
forward-looking statements to reflect new events or circumstances.  We
caution you that a variety of factors, including but not limited to the factors
described below under Item 1A Risk Factors and the following, could cause our
business conditions and results to differ materially from what is contained in
forward looking statements:





-
            changes
      in the rate of economic growth in the United States and other major
      international economies;




-
            changes
      in investment by the nuclear and fossil electric utility industry, the
      chemical and petrochemical industries and the U.S.
    military;


-
            changes
      in the financial condition of our
customers;


-
            changes
      in regulatory environment;


-
            changes
      in project design or schedules;


-
            contract
      cancellations;


-
            changes
      in our estimates of costs to complete
projects;


-
            changes
      in trade, monetary and fiscal policies
  worldwide;


-
            currency
      fluctuations;


-
            war
      and/or terrorist attacks on facilities either owned or where equipment or
      services are or may be provided;


-
            outcomes
      of future litigation;


-
            protection
      and validity of our trademarks and other intellectual property
      rights;


-
            increasing
      competition by foreign and domestic
companies;


-
            compliance
      with our debt covenants;


-
            recoverability
      of claims against our customers and others;
and


-
            changes
      in estimates used in our critical accounting
  policies.






3


Other factors and assumptions not
identified above were also involved in the formation of these forward-looking
statements and the failure of such other assumptions to be realized, as well as
other factors, may also cause actual results to differ materially from those
projected. Most of these factors are difficult to predict accurately
and are generally beyond our control. You should consider the areas of risk
described above in connection with any forward-looking statements that may be
made by us.You should not place undue reliance on any forward-looking statements. New
factors emerge from time to time, and it is not possible for us to predict which
factors will arise.




We undertake no obligation to publicly
update any forward-looking statements, whether as a result of new information,
future events or otherwise. You are advised, however, to consult any additional
disclosures we make in proxy statements, quarterly reports on Form 10-Q and
current reports on Form 8-K filed with the SEC.
















PART I








ITEM 1.
            BUSINESS.





GSE Systems, Inc. (“GSE Systems”,
“GSE”, the “Company”, “our”, “we” or “us”), a Delaware corporation organized in
March 1994, is a world leader in real-time, high fidelity
simulation.  The Company provides simulation and educational solutions
and services to the nuclear and fossil electric utility industry and the
chemical and petrochemical industries. In addition, the Company provides plant
monitoring, and signal analysis monitoring and optimization software primarily
to the power industry.  GSE is the parent company of GSE Power
Systems, Inc., a Delaware corporation; GSE Power Systems, AB, a Swedish
corporation; GSE Engineering Systems (Beijing) Co. Ltd, a Chinese limited
liability company; and has a 10% minority interest in Emirates Simulation
Academy, LLC, a United Arab Emirates limited liability company.





The Company’s annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K, and all amendments to those reports filed or furnished pursuant
to Section 13(a) or 15(d) of the Exchange Act (15 U.S.C. 78m(a) or 78o(d) will
be made available free of charge through the Investor Relations section of the
Company’s Internet website (http://www.gses.com) as soon as practicable after
such material is electronically filed with, or furnished to, the
SEC.  In addition, the public may read and copy any materials we file
with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington,
DC 20549.  The public may obtain information on the operation of the
Public Reference Room by calling the SEC at 1-800-SEC-0330.  The SEC
maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC at http://www.sec.gov.








Recent
Developments.





On June
22, 2007, the Company raised $9.2 million, net of associated fees of $768,000,
through the sale of 1,666,667 shares (the “Shares”) of its common stock, $.01
par value per share, by means of a private placement to selected institutional
investors.  Each investor received a five-year warrant to purchase GSE
common stock (the “Warrant Shares”) equal to 10% of the shares of common stock
that each investor purchased at an exercise price of $6.00 per share (the
“Warrants”).  In aggregate, the Company issued Warrants to purchase a
total of 166,667 shares of GSE common stock.


4


The
Company filed its registration statement on Form S-3 with the Securities and
Exchange Commission (the “Commission”) on July 16, 2007 covering the offer and
sale, from time to time, of the Shares, the Warrant Shares and shares of common
stock issuable upon exercise of warrants that may be issued as liquidated
damages under the terms of a certain registration rights agreement entered into
between the Company and the investors (the “Registration Rights Agreement”) in
connection with the private placement.  The Registration Statement
became effective on August 8, 2007 and, pursuant to the provisions of the
Registration Rights Agreement, the Company is obligated to use commercially
reasonable efforts to, after the date on which the Registration Statement
becomes effective, cause the Registration Statement to remain continuously
effective as to all Shares and Warrant Shares, other than for an aggregate of
more than 30 consecutive trading days or for more than an aggregate of 60
trading days in any 12-month period. In the event of a default of the foregoing
obligation, the Company will be required to issue to the investors, as
liquidated damages, on the date the foregoing default occurs and each monthly
anniversary thereafter, a number of warrants (on the same terms as the Warrants)
equal to 2% of the number of Shares then held by such investor, not to exceed
10% of the total number of Shares then held by such investor, and thereafter
cash, in an amount equal to 2% of the aggregate purchase price paid by the
investors, not to exceed 30% of the aggregate purchase price paid by the
investors.





The
Company paid the placement agent for the Shares and Warrants 6% of the gross
proceeds received by the Company from the offering ($600,000).  In
addition to the placement agent fee, the Company paid $168,000 of other
transaction fees related to the offering.





The proceeds were used to pay down
the Company’s line of credit and for other working capital
purposes.





At a special shareholder’s meeting on
December 13, 2007, the Company’s shareholders approved an amendment to the
Company's Certificate of Incorporation increasing GSE’s authorized common stock
by 12 million shares to a total of 30 million shares.  In addition,
the shareholders approved an amendment to the Company’s 1995 Long-Term Incentive
Plan (amended and restated September 25, 2007) (the “Plan”) which increased the
number of shares available under the Plan by 1 million shares to a total of
3.5 million shares and extended the life of the Plan by an additional 10 years
to June 30, 2018.  The Company has reserved 1 million shares of
the newly authorized common stock for issuance pursuant to the provisions of the
Plan.





The
Company is finalizing two new loan and security agreements with Bank of America
that will provide revolving lines of credit up to an aggregate $5.0 million. The
Company and its subsidiary, GSE Power Systems, Inc., will be jointly and
severally liable as co-borrowers.  The credit facilities will enable
the Company to borrow funds to support working capital needs and standby letters
of credit.  The first line of credit in the principal amount of $3.5
million will enable the Company to borrow funds up to 90% of eligible foreign
accounts receivable, and 75% of eligible unbilled foreign receivables. The line
of credit will be 90% guaranteed by the Export-Import Bank of the United
States.  The interest rate on this line of credit will be based on the
one-month LIBOR rate plus 150 basis points, with interest only payments due
monthly.  The second line of credit in the principal amount of $1.5
million will enable the Company to borrow funds up to 80% of domestic accounts
receivable and 30% of domestic unbilled receivables.  The interest
rate on this line of credit will be based on the one-month LIBOR rate plus 225
basis points, with interest only payments due monthly.   The
credit facilities will require the Company to comply with certain financial
ratios and preclude the Company from paying dividends and making acquisitions
beyond certain limits without the bank’s consent.  The Company expects
to close on the new loan and security agreements by March 31,
2008.


On June 21, 2005, the Board of
Directors of GP Strategies Corporation (“GP Strategies”) approved plans to
spin-off its 57% interest in GSE through a special dividend to the GP
Strategies’ stockholders.  On September 30, 2005, the GP Strategies’
stockholders received 0.283075 share of GSE common stock for each share of GP
Strategies common stock or Class B stock held on the record date of September
19, 2005.  Following the spin-off, GP Strategies ceased to have any
ownership interest in GSE.  GP Strategies continued to provide
corporate support services to GSE, including accounting, finance, human
resources, legal, network support and tax pursuant to a Management Services
Agreement which expired on December 31, 2006.





5


The
nuclear power industry has been largely dormant for the last thirty years with
few opportunities to provide new full scope simulators.  The Company’s
nuclear simulation business has concentrated mainly on providing services to the
installed base of nuclear simulators worldwide.  These services are
primarily related to upgrading antiquated simulation software and hardware
systems, providing new and improved plant and system simulation models, and
modifying the simulator to reflect changes in the physical
plant.  However, over the last several years, the nuclear power
industry has experienced a dramatic change, and most energy experts believe the
industry is on the verge of a “renaissance”, driven by the gap between the
energy that the world is projected to need versus the current capacity, the
rising cost of oil, and growing environmental concerns caused by fossil fuels.
Government and industry sources and trade journals report that up to 200 new
nuclear plants will be built over the next 20 years.   In the
U.S. alone, applications for accelerated construction and operating licenses
have been submitted for 35 new nuclear plants.  Each new plant will be
required to have a full scope simulator ready for operator training and
certification about two years prior to plant operation.  Similar
nuclear plant construction programs are underway or planned in China, Russia,
Ukraine, Japan and Central Europe to meet growing energy demands.  In
addition, most U.S. nuclear electric utilities have applied for license
extensions and/or power upgrades.  These license extensions will lead
to significant upgrades to the physical equipment and control room technology
which will result in the need to modify or replace the existing plant control
room simulators. The Company, having what it believes is the largest installed
base of existing simulators, over 60% on a global basis, is well positioned to
capture a large portion of this business, although no assurance can be given
that it will be successful in doing so.  The Company logged
approximately $21.5 million, $12.2 million and $10.3 million in nuclear
simulation orders in the years ended December 31, 2007, 2006 and 2005,
respectively.





In 2005,
the Company completed an agreement with Westinghouse Electric Company LLC
(“Westinghouse”) to become their preferred vendor for the development of
simulators for their AP1000 reactor design.  As a result of this
agreement, GSE is working closely with Westinghouse to cooperate in the
development of simulators for the AP1000 design and assist Westinghouse in the
verification and validation of the AP1000 Human Machine
interface.  The Company’s simulation models have been used to help
Westinghouse successfully complete several phases of Human Machine Interface
testing with US regulators.  In September 2007, GSE received an
initial contract from Westinghouse to begin work on the Sanmen simulator project
in China.  Westinghouse and its consortium partners received
definitive multi-million dollar contracts from State Nuclear Power Technology
Corporation Ltd., Sanmen Nuclear Power Company Ltd., Shandong Nuclear Power
Company Ltd., and China National Technical Import & Export Corporation to
provide four AP1000 nuclear power plants in China.  The four plants
are to be constructed in pairs on China’s eastern coast at Sanmen in Zhejiang
province and Haiyang in Shandong province. In February 2008, the Company
received the balance of its multi-million dollar order from
Westinghouse.  The Westinghouse agreement is not exclusive and does
not prevent the Company from working with other nuclear vendors anywhere in the
world.





The
Company’s fossil fueled power simulation business has been growing rapidly over
the past three years.  The Company logged approximately $11.2
million, $4.8 million, and $3.8 million of fossil fueled simulation orders for
the years ended December 31, 2007, 2006 and 2005,
respectively.   The transition from obsolete analog control
systems to modern digital control systems and the new requirements for complex
emission control systems are contributing to the growth the Company is
experiencing in this business, coupled with the fact that GSE’s high-fidelity
simulation models can be used to validate control schemes and logics for new
designs before the control systems are deployed to the field.  GSE
builds the plant models based upon design specifications supplied by its
customers, and the models then drive the actual digital control systems in the
factory.  This testing can uncover numerous control system
discrepancies.  By correcting these problems at the factory versus in
the field, GSE's customers can save millions in reduced down time and reduced
commissioning time.







6


GSE’s
process industries simulation business customers include primarily oil and gas
production facilities, oil refining plants, chemical plants and petro-chemical
facilities.  The increased need for oil and oil based refined products
coupled with the rising price of oil is creating a global expansion in oil
production facilities.  In addition, there is more focus on regular,
periodic and systematic training of plant operator personnel which may reduce
the risk of operator errors and potentially catastrophic environment
disasters and/or loss of life.   The Company logged
approximately $3.4 million, $1.5 million, and $849,000 of process industry
simulation orders for the years ended December 31, 2007, 2006 and 2005,
respectively.





In July
2007, the Company announced that it had entered into a strategic partnership
with Sinopec Ningbo Engineering Company (“SNEC”).  SNEC is a
wholly-owned subsidiary of SINOPEC and its 3,500 employees provide engineering,
manufacturing, construction and maintenance services to the oil, chemical and
petrochemical industries.  This partnership will enable GSE and SNEC
to jointly explore, collaborate and build high fidelity, real-time simulators
for the oil, chemical and petrochemical industries.  The first
multi-million dollar project under this strategic partnership that GSE has been
authorized to commence is at SINOPEC’s Fujian Refinery.  Specifically,
SNEC and GSE will be responsible for the development of a simulator, including
high fidelity models, for the Fujian Refinery Integrated Gasification Combine
Cycle Plant.





The
Company continues to develop its concept of integrating simulation with broader
training programs and educational initiatives giving customers a turnkey
alternative to traditional on-site operator and maintenance
training.  Work continued on the $15.1 million order received in 2006
from ESA to supply five simulators and an integrated training program. A $1.7
million change order was received from ESA in late 2007 increasing the total
order value to $16.8 million.   At December 31, 2007, $1.1
million of backlog remained on this project.








Background.





GSE Systems was formed on March 30,
1994 to consolidate the simulation and related businesses of S3 Technologies,
General Physics International Engineering & Simulation and EuroSim, each
separately owned and operated by ManTech International Corporation, GP
Strategies Corporation and Vattenfall AB, respectively.





In December 1997, the Company acquired
100% of the outstanding common stock of J.L. Ryan, Inc. (“Ryan”), a provider of
engineering modifications and upgrade services to the power plant simulation
market.  The combination of the Company’s pre-existing technology with
the technical staff of the acquired Ryan business positioned the Company to be
more competitive for modifications and upgrade service projects within the
nuclear simulation market.





In October 2002, GSE purchased the
stock of ManTech Automation Systems (Beijing) Company Ltd, from ManTech
International Corp.  The Chinese company, which has ten employees, was
renamed GSE Systems Engineering (Beijing) Company Ltd. This acquisition gave the
Company a base in China to pursue and implement simulation projects in that
emerging market.







7




Simulation
Business.





I.  Nuclear and Fossil Fuel Power
Simulation.





Industry History


The real-time simulation industry
grew from the need to train people on complex and potentially dangerous
operations, without placing life or capital assets at risk.  Real-time
simulation has been used for the training of plant operators for the power
industry, including both nuclear power plants and conventional fossil fuel power
plants (i.e., coal, oil, and natural gas), since the early
1970s.  Real-time simulation usage has traditionally centered on
initial training of operators and follow-on training of operators in emergency
conditions that can best be achieved through simulation replicating actual plant
operations.





In the nuclear power industry, use of a
simulator that accurately reflects the current actual plant design is mandated
by the U.S. Nuclear Regulatory Commission.  This mandate resulted from
the investigation of the accident at the Three Mile Island nuclear plant in
1979, which was attributed, at least in part, to operator error.  The
NRC requires nuclear plant operators to earn their licenses through simulator
testing.  Each nuclear plant simulator must pass a certification
program to ensure that the initial plant design and all subsequent changes made
to the actual plant control room or plant operations are accurately reflected in
the simulator.  Plant operating licenses are tied to simulator
certification.





Full scope power plant simulators are a
physical representation of the entire plant control room.  The control
panels are connected to an input/output (I/O) system, which converts analog
electrical signals to digital signals understood by the simulation
computer.  The simulation computer houses the mathematical models,
which simulate the physical performance of the power plant’s systems such as the
reactor core, steam boiler, cooling water, steam turbine, electrical generator,
plant system controls and electrical distribution systems.  Partial
scope simulators can be viewed as a subset of a full scope
simulator.  Instead of simulating the entire performance of the power
plant, a partial scope simulator might represent one or two critical systems
such as the steam turbine and/or electrical generator operation.





In the past, training simulators had to
strike a delicate balance between providing an accurate engineering
representation of the plant, while still operating in “real-time” in order to
provide effective training.  As computing power has increased, so too
has the capacity of simulators to provide more accurate plant representations in
real-time based upon simulation models developed from engineering design
codes.





Simulation also is used to validate
proposed plant equipment changes and to confirm the results of such changes,
prior to making the change in the plant, which can save time and money, as well
as reduce the risk of unsafe designs, for the utility.





The importance of nuclear power to the
U.S. energy supply is resulting in the extension of the useful lives of U.S.
nuclear power plants.  Any service life extension of a nuclear power
plant is likely to require major upgrades to the plant's equipment and
technology, including its simulator.





Fossil fuel plant simulators are not
required by law or regulation, but are justified as a cost-effective approach to
train operators on new digital control systems being implemented at many fossil
fuel power plants.  The size, complexity and price of a fossil plant
simulator are much lower than for simulators used for nuclear
plants.  Fossil plant simulators have traditionally used lower
fidelity (less sophisticated) mathematical models to provide an approximate
representation of plant performance.  The demand for highly accurate
models did not exist in the early market for fossil simulators since the main
use of the simulator was to train operators on the functionality of distributed
control systems for plant start-up activities.







8


The
deregulation of the power industry has forced utilities to view their assets
differently.  Power plants must now be profit centers, and gaining the
maximum efficiency from the plant to become, or remain, competitive is a
paramount issue.  The mindset of the operator has shifted, as plant
operators now must perform within narrower and narrower performance margins
while still maintaining safe operations.  GSE believes its fossil fuel
plant customers are now recognizing the benefits of high fidelity simulation
models that provide highly accurate representations of plant operations to help
plant operators and management determine optimal performance
conditions.





Beyond traditional operator training
uses, the Company sees a significant shift in the use of its simulators to test
plant automation systems before they are deployed in the actual
plant.  Control strategies and equipment set points are validated on
the simulator prior to plant start up to ensure the control schemes work
properly and the expected plant performance is achieved.  Performing
these tests on a high fidelity simulator saves days or weeks in the plant start
up, thereby reducing cost and ensuring quicker revenue generation by the
utility.





Industry Future





The Company sees a renaissance in
nuclear power generation both domestically and internationally that will provide
significant opportunities for expansion of the Company’s
business.  China has announced plans to build 40 new nuclear plants by
the year 2020.  Russia has also announced plans for 40 new plants by
2030.  New plants are on the drawing board or under construction in
Finland, Slovakia, and Bulgaria.  Domestically, numerous utilities are
preparing applications for Construction and Operating Licenses under the
Department of Energy 2010 incentive program, a joint government/industry
cost-shared effort to identify sites for new nuclear power plants, develop
advanced nuclear plant technologies, and demonstrate new regulatory processes
leading to a private sector decision to order new nuclear power plants for
deployment in the United States in the 2010 timeframe.  Beyond new
construction, numerous U.S. utilities are extending the useful life of their
current assets.





These license extension processes in
the nuclear industry will result in significant changes in plant equipment and
control room technology. Based upon U.S. Nuclear Regulatory Commission
regulations, each training simulator is required to reflect all changes that are
made in the actual plant, thus when changes in plant equipment and control room
technology are made, the nuclear power plants must either upgrade existing
simulators or purchase brand new simulators.





The second phenomena affecting the
industry is the aging of the nuclear and fossil plant operator workforce which
will result in the need for simulation to train the next generation of plant
operators.  The industry is faced with an aging workforce at the same
time new capacity is needed, thereby placing significant pressure on the
industry to find and train the next generation of operations and maintenance
personnel.  According to the Energy Central Research and Analysis
Division white paper entitled The High Cost of Losing Intellectual
Capital,the U.S. Bureau of Labor Statistics predicts that 30% or more of
the existing workforce will be eligible for retirement in the next five years,
and it is believed that by 2012 there will be nearly 10,000 more utility
industry jobs then workers to fill them.





Therefore, the Company believes that
these trends, if they come to fruition in whole or even in part, represent a
market opportunity for its real-time simulation, plant optimization, asset
management and condition monitoring products and services.





9




GSE’s Solution
  The
Company’s Power Simulation business is a leader in the development, marketing
and support of highfidelity, real-time, dynamic simulation software for
the electric utility industry.  The Company has built or modified
about 65 of the approximately 75 full-scope simulators serving about 103
operating nuclear power plants in the United States.  Outside the
United States, GSE has built or modified about 73 of the approximately 167
full-scope simulators serving approximately 329 operating nuclear power
plants.




The
Company has developed integrated training solutions which combine the power of
the Company’s simulation technology with training content to provide turn-key
training for the power and process industries.  These training centers
will help industry bridge the gap between college and university level training,
and real world experience through
simulation.  The students that graduate from GSE’s training centers
will be eminently more valuable to the market place.





In addition to operator training, the
Company’s simulation products and services permit plant owners and operators to
simulate the effects of changes in plant configuration and performance
conditions to optimize plant operation.  These features allow the
Company’s customers to understand the cost implications of replacing a piece of
equipment, installing new technology or holding out-of-service
assets.  GSE has also developed a suite of tools based on
sophisticated signal analysis and simulation techniques to help its customers
manage their assets by determining equipment degradation before it severely
impacts plant performance.





The Company has also focused on
upgrading older technology used in power plants to new technology upgrades for
plant process computers and safety parameter display systems.  As
nuclear plants in the U.S. continue to age, the Company will seek more business
in this upgrade market.





GSE provides both turn-key solutions,
including simulated hardware and proprietary software, to match a specific
plant, and discrete simulation technology for specific uses throughout a
plant.  Its substantial investment in simulation technology has led to
the development of proprietary software tools.  These tools
significantly reduce the cost and time to implement simulation solutions and
support long-term maintenance.  The Company’s high fidelity, real-time
simulation technology for power plant fluid, logic and control, electrical
systems and associated real-time support software, JADE, is available for use
primarily on UNIX, Linux and Windows computer platforms.  The
Company’s eXtreme tools were designed for the Windows
environment.  Both technologies were specifically designed to provide
user friendly graphic interfaces to the Company’s high fidelity
simulator.





In addition to the simulator market,
the Company offers products aimed at improving performance of existing plants by
reducing the number of unplanned outages due to equipment
failure.  Using advanced signal analysis techniques, the Company’s
tools can predict when certain plant equipment needs to be
replaced.  Replacement of critical equipment prior to failure permits
effective planning and efficient use of maintenance time during scheduled
off-line periods.





Products of the Power Simulation
business include:





 ̈
            Java Applications &
      Development Environment (JADETM),a
      Java-based application that provides a window into the simulation
      instructor station and takes advantage of the web capabilities of Java,
      allowing customers to access the simulator and run simulation scenarios
      from anywhere they have access to the web.  JADE includes the
      following software modeling tools:


 ̈
            JflowTM, a
      modeling tool that generates dynamic models for flow and pressure
      networks.


 ̈
            JcontrolTM, a
      modeling tool that generates control logic models from logic
      diagrams.


 ̈
            JlogicTM,a
      modeling tool that generates control logic models from schematic
      diagrams.


10


 ̈
            JelectricTM,a
      modeling tool that generates electric system models from schematic and
      one-line diagrams.


 ̈
            JtopmeretTM, a
      modeling tool that generates two phase network dynamic models.


 ̈
            JdesignerTM,a
      JADE based intuitive graphic editor for all JADE tools.


 ̈
            JstationTM,a
      JADE based web-enabled Instructor
Station.





 ̈
            eXtreme ToolsTM, a
      suite of software modeling tools developed under the Microsoft Windows
      environment.  It
includes:


 ̈
            XtremeFlowTM,
      amodeling
      tool that generates dynamic models for flow and pressure
      networks.


 ̈
            XtremeControlTM,amodeling tool
      that generates control logic models from logic
  diagrams.


 ̈
            XtremeLogicTM,a
      modeling tool that generates control logic models from schematic
      diagrams.


 ̈
            Xtreme ElectricTM, a
      modeling tool that generates electric system models from schematic and
      one-line diagrams.





 ̈
            SimExec® and
      OpenSim®,
      real-time simulation executive systems that control all real-time
      simulation activities and allow for an off-line software development
      environment in parallel with the training environment.  OpenSim is targeted for
      users of Microsoft Windows operating systems, while SimExec is targeted for
      users of Microsoft Windows, UNIX and Linux operating
      systems.





 ̈
            SmartTutor®,
      complementary software for instructor stations.  It provides new
      capabilities to help improve training methodologies and
      productivity.  Using Microsoft Smart Tag technology, SmartTutor
      allows the control of the simulator software directly from Microsoft
      Office products.  The user can run training scenarios directly
      from a Microsoft Word document, or he can plot and show transients live
      within a Microsoft PowerPoint
slide.





 ̈
            eXtreme I/STM, a
      Microsoft Windows based Instructor Station that allows the use of
      Microsoft Word and PowerPoint to control the real-time simulation
      environment. eXtreme I/S is a user-friendly tool for classroom training
      and electronic report generation.  It provides real-time plant
      performance directly from the simulator during classroom training, which
      drastically increases learning
efficiency.





 ̈
            Pegasus Surveillance and
      Diagnosis SystemTM, a software package for semi-automatic plant
      surveillance and diagnostics, incorporates sophisticated signal processing
      and simulation techniques to help operators evaluate the condition and
      performance of plant components.  Pegasus permits plant
      management to identify degraded performance and replace components before
      they fail.





 ̈
            SIMONTM, a
      computer workstation system used for monitoring stability of boiling water
      reactor plants. SIMON assists the operator in determining potential
      instability events, enabling corrective action to be taken to prevent
      unnecessary plant shutdowns.





The Simulation business also provides
consulting and engineering services to help users plan, design, implement, and
manage/support simulation and control systems. Services include application
engineering, project management, training, site services, maintenance contracts
and repair.





Strategy




The goal
of the Power Simulation business is to expand its business on three
fronts:


 ̈
            Continue
      serving its traditional customer
base.


11


 ̈
            Combine
      its simulation capability with training content to provide totally
      integrated training solutions.


 ̈
            Leverage
      its existing engineering staff to provide additional services to domestic
      and international clients.





Traditional Simulation
Market.Nuclear power currently accounts for about 20% of the
electrical power grid capacity in the United States and this percentage will
likely remain the same even as total capacity increases.  Any new
nuclear power plants will likely be of the advanced reactor designs created by
Westinghouse, General Electric and Areva.  These new designs require
new simulators and training programs, as they are different from the nuclear
power plant designs currently in operation. In addition to new power plants,
existing nuclear power plants will likely be required to remain on-line for a
longer period than originally expected.  In order to stay in
operation, many plants will require life extension
modifications.  Since all existing U.S. nuclear power plants went
on-line before 1979, their designs and technology can also benefit from the
substantial advances in plant design and technology developed over the past 25
years.  For example, several of the Company’s U.S. utility customers
are considering replacing their existing hard panel control rooms with modern
distributed control systems (DCS) as are common in fossil fuel plants, and which
have been implemented in Europe for several years.   Significant
changes to control room instrumentation and overall control strategy from hard
panel to DCS generally require modification or replacement of the plant
simulator. With the largest installed base of nuclear plant simulators in the
world, the Company believes it is uniquely positioned to serve this market
segment with new simulation products and services.  GSE has received
several projects in the last few years for implementing digital turbine control
systems in U.S. plants.





As plants extend their useful life,
many plan to “up-rate” the existing capacity to increase electrical
yield.  By changing the capacity of certain equipment in a plant, the
utility can gain upwards of a 10%-15% increase in output.  Again, any
such changes must be reflected in the control room simulator, and operators must
be trained on the new equipment before implementation.





In addition to the United States
markets, several emerging regions of the world are expanding their electrical
capacity with both nuclear and fossil fuel power plants. This is particularly
the case in China and the Gulf Region of the Middle East.  In 2006,
the Company received its first contract for a fully integrated training academy
in the United Arab Emirates.  The Emirates Simulation Academy, LLC
will use five simulators developed by the Company for gas turbine plants,
combined cycle power plants, oil refineries, oil platforms and desalination
plants.  In addition, the Company is providing the training content
for both classroom and simulator training.  The Company sees other
opportunities for similar academies in other regions of the world.





Classroom
Simulation.  In recent years the Company has upgraded numerous
training simulators to utilize standard PC technology.  As an
extension of the PC-based simulator technology, the Company has developed tools
which will allow the training simulator to be used in a classroom setting,
replacing the actual control room panels with “soft-panel”
graphics.





Increased training requirements and
demands for performance improvement have resulted in simulator training time
becoming scarce.  By providing the actual training simulator models in
a classroom setting, the value of the simulator is increased by allowing more
personnel the training advantages of interactive, dynamic real-time
simulation.





The Company pioneered the technology to
run a simulator on a PC several years ago.  However, the technology
remains complex, which prevented wide deployment of the simulator in
classrooms.  The Company has developed unique software which allows
simulator-based training lessons to be easily developed and deployed in a
classroom setting.


12




Simulation Beyond
Training.In addition to operator training, the Company’s
simulation products can meet this increased need for efficiency by assisting
plant operators in understanding the cost implications of replacing equipment,
installing new technology and maintaining out-of-service assets.  In
order to exploit this potential, the Company has increased the fidelity of its
simulation products and is marketing its services to increase the fidelity of
simulators that are already in operation.





As computing power and networking
technologies improve, several of the Company’s customers have started to migrate
simulation technology from the training organization to the engineering
organization.  The same full scope simulation software that drives the
simulated control room panels in a simulator can be used with graphical
representations of the panels so engineers can test design changes and see how
the balance of the plant will react to such changes. GSE has developed a
Java-based application to allow customers easier access to, and use of, the
simulation capabilities across the organization through network
communication.





Optimize Existing Engineering
Resources.  GSE’s Power domestic service organization focuses
on simulator upgrades and retrofits.  In addition to domestic
resources, GSE has developed a network of trained engineers in Russia, Ukraine,
Czech Republic, Bulgaria, and China.  These foreign resources provide
low cost engineering and software development capabilities and are readily
available to supplement the United States engineering staff as
necessary.





Strategic Alliances





Power’s
strategic alliances have enabled the Company to penetrate regions outside the
United States by combining the Company’s technological expertise with the
regional presence and knowledge of local market participants.  These
strategic alliances have also permitted the reduction of research and
development and marketing costs by sharing such costs with other
companies.





In recent
years, a significant amount of the Company’s international business has come
from contracts in Eastern Europe, including the republics of the former Soviet
Union, and the Pacific Rim.  In order to acquire and perform these
contracts, the Company entered into strategic alliances with various entities
including All Russian Research Institute for Nuclear Power Plant Operation
(Russia); Kurchatov Institute (Russia); Risk Engineering Ltd. (Bulgaria);
Samsung Electronics (Korea); Sinopec Ningbo Engineering Company (China); Toyo
Engineering Corporation (Japan); and Westinghouse Electric Company LLC
(U.S.).  In March 2006, GSE completed a strategic alliance with the
University of Strathclyde in Glasgow, UK to develop a simulation training and
plant diagnostics center to serve the UK.




Competition





The Power
Simulation business encounters intense competition.  In the nuclear
simulation market, GSE competes directly with larger firms primarily from Canada
and Germany, such as L-3 Communications, MAPPS Inc. and STN
Atlas.  The fossil simulation market is represented by smaller
companies in the U.S. and overseas.


13


Several
of the Company’s competitors have greater capital and other resources than it
has, including, among other advantages, more personnel and greater marketing,
financial, technical and research and development
capabilities.  Customer purchasing decisions are generally based upon
price, the quality of the technology, experience in related projects, and the
financial stability of the supplier.





Customers





The Power
Simulation business has provided approximately 200 simulation systems to an
installed base of over 75 customers worldwide.  In 2007, approximately
71% of the Company’s revenue was generated from end users outside the United
States.   Customers include, among others, ABB Inc., American
Electric Power, Bernische Kraftwerke AG (Switzerland), British Energy Generation
Ltd. (UK), Comission Federal De Electricidad (Mexico), Emerson Process
Management, Emirates Simulation Academy, LLC (UAE),  Honeywell Hi-Spec
Solutions (Canada), Kapar Energy Ventures SDN BHD (Malaysia), Karnkraftsakerhet
och Utbildning AB (Sweden), Battelle’s Pacific Northwest National Laboratory,
Nuclear Engineering Ltd. (Japan), Pebble Bed Modular Reactor (Pty) Ltd. (South
Africa), PSEG Nuclear, Inc., and Rosenergoatom Federal State Owned Enterprise
(Russia).





For the
year ended December 31, 2007, the Emirates Simulation Academy LLC (UAE) provided
31% of the Company’s consolidated revenue (21% in 2006 and none in 2005);
Rosenergoatom Federal State Owned Enterprise (Russia) provided 9% of the
Company’s consolidated 2007 revenue (12% in 2006 and none in 2005), and
Battelle’s Pacific Northwest National Laboratory accounted for approximately 4%
of the Company’s consolidated revenue (11% and 25% in 2006 and 2005,
respectively).   The Pacific Northwest National Laboratory is the
purchasing agent for the Department of Energy and the numerous projects the
Company performs in Eastern and Central Europe.





Sales and Marketing





The Company markets its Power
Simulation products and services through a network of direct sales staff, agents
and representatives, systems integrators and strategic alliance partners.
Market-oriented business and customer development teams define and implement
specific campaigns to pursue opportunities in the power
marketplace.





The Company’s ability to support its
multi-facility, international and/or multinational Power Simulation clients is
facilitated by its network of offices and strategic partners in the U.S. and
overseas. Power Simulation offices are maintained in Maryland and Georgia, and
outside the U.S., in Sweden and China.  In addition to the offices
located overseas, the Company’s ability to conduct international business is
enhanced by its multilingual and multicultural work force. GSE has strategic
relationships with systems integrators and agents representing its interests in
the Czech Republic, Bulgaria, Germany, Japan, Mexico, People’s Republic of
China, South Africa, Spain, South Korea, Taiwan, Ukraine and the United
Kingdom.




14


II.  Process Industries
Simulation.
 
 Industry
 
 Throughout the process
industries there is continuing competitive pressure, reduction of technical
resources, and an aging workforce
which is forcing process manufacturers to turn to advanced technologies for
real-time optimization, training, and advanced process
control.  Operational efficiency is vital for companies to remain
competitive where many of the manufacturing industries operate on very thin
margins. There are only one or two advanced technology companies that offer
services fully across this spectrum, and GSE offers dynamic real-time simulation
capabilities for operator training into this segment.





GSE’s Solution




The
SimSuite Pro product was developed by GSE specifically for operator training,
and the GSE culture and expertise is one of customized project execution and
delivery.  This marketplace places a high value on experience, both
company-wide and for the individuals on the project teams, so GSE promotes its
long history in training simulators, while also seeking new applications. The
SimSuite Pro package continues to be enhanced with features applicable not just
to the execution of professional training techniques, but also to the recording
and validating of process operator performance for potential
certification.




Strategy




GSE is
uniquely positioned in the process simulation market to provide total training
solutions which combine the development of the plant simulator with the training
infrastructure and course material to enable the customer to truly benefit from
the simulator investment.  The core concepts of process simulation
make the technology a basis for other potential process improvement activities,
such as Advanced Process Control and Process Optimization, which is where some
of the major GSE competition has more business focus than for operator training.
GSE will continue to emphasize its operator training focus and strengths, as
well as the application of the process simulator for change management, where
changes in the process, control strategy, or operating procedures can be
evaluated in real time before they are applied to the actual process units.
On-stream time is an important economic factor, and there is recognizable value
in avoiding the risk of unplanned process disturbances from invalidated
changes.





An
emerging energy market is developing for Integrated Gasification Combined Cycle
(“IGCC”) power plants.  These new plants produce electricity more
efficiently than traditional power plants by first converting existing refinery
waste materials into synthetic gas that is used to power a gas
turbine.  The gas is then burned to create steam to turn a steam
turbine.  The unique nature of these plants requires expertise both in
chemical process simulation and power simulation.  GSE is one of the
few simulator companies in the world with expertise in both areas.





In 2007,
GSE was awarded a contract from Sinopec Ningbo Engineering Company (“SNEC”) to
build an IGCC simulation platform for design verification and validation of the
Fujian IGCC plant in China.  GSE also formed a strategic alliance with
SNEC to build simulators for the SNEC designed refineries and IGCC plants
throughout China.




Customers





Hydrocarbon and chemical process
customers include numerous large oil refineries and chemical plants such as
Statoil ASA of Norway, Bayernoil of Germany, Saudi Basic Industries Corporation
of Saudi Arabia, Sinopec of China, and Washington Savannah River Company of the
U.S.


15





Competition





GSE’s
process simulation competitors are a varied group. There are major corporations
offering a wide range of products and services that include operator training
simulators.  There are also companies focused on Process Technology
and manufacturing enhancement, such as Invensys and Honeywell who are
Distributed Control System (“DCS”) distributors to the refining industry and
provide operator simulation as part of their DCS
offering.   There is a collection of companies with specific
industry niches that enables them to compete in operator training simulation,
such as Invensys and RSI. There are also the smaller training companies that
compete at the lower cost levels of Computer Based Training (“CBT”) or simple
simulations close to CBT.





The GSE focus on training simulation is
a business strength, and its vendor independence, with the ability to integrate
to different vendor’s process control systems, is also a value which is
appreciated by customers. GSE can be seen as a best-of-breed type of supplier
because it is not tied to a major control system,nor is itproviding simulation
software for engineering and business management with high annual license
fees.




Sales and Marketing





The Company will market its Process
Simulation technologies through a combination of techniques including its
existing direct sales channel, sales agents, and strategic alliance
partners.





Competitive
Advantages.





The Company believes that it is in a
strong position to compete in the Simulation markets based upon the following
strengths:





 ̈
            Technical and Applications
      Expertise.  GSE is a leading innovator and developer of
      real-time software with more than 30 years of experience producing high
      fidelity real-time simulators.  As a result, the Company has
      acquired substantial applications expertise in the energy and industrial
      process industries.  The Company employs a highly educated and
      experienced multinational workforce of 153 employees, including
      approximately 108 engineers and scientists.  Approximately 50%
      these engineers and scientists have advanced science and technical degrees
      in fields such as chemical, mechanical and electrical engineering, applied
      mathematics and computer sciences.





 ̈
            Proprietary Software
      Tools.  GSE has developed a library of proprietary
      software tools including auto-code generators and system models that
      substantially facilitate and expedite the design, production and
      integration, testing and modification of software and
      systems.  These tools are used to automatically generate the
      computer code and systems models required for specific functions commonly
      used in simulation applications, thereby enabling it or its customers to
      develop high fidelity real-time software quickly, accurately and at lower
      costs.





 ̈
            Open System
      Architecture.  GSE’s software products and tools are
      executed on standard operating systems with third-party off-the-shelf
      hardware.  The hardware and operating system independence of its
      software enhances the value of its products by permitting customers to
      acquire less expensive hardware and operating systems.  The
      Company’s products work in the increasingly popular Microsoft operating
      environment, allowing full


16


 ̈
            utilization
      and integration of numerous off-the-shelf products for improved
      performance.





 ̈
            Training
      Curricula.   The Company has developed detailed
      course material in engineering fundamentals and specific industrial
      applications.





 ̈
            International
      Strengths.  Approximately 71% of the Company’s 2007
      revenue was derived from international sales of its products and
      services.  GSE has a multinational sales force with offices
      located in Beijing, China, and Nyköping, Sweden and agents,
      representatives and partners in 20 other countries. To capitalize on
      international opportunities and penetrate foreign markets, the Company has
      established strategic alliances and partnerships with several foreign
      entities and universities.








Intellectual Property.





The
Company depends upon its intellectual property rights in its proprietary
technology and information.  GSE maintains a portfolio of trademarks
(both registered and unregistered), copyrights (both registered and
unregistered), and licenses.  While such trademarks, copyrights and
licenses as a group are of material importance to the Company, it does not
consider any one trademark, copyright, or license to be of such importance that
the loss or expiration thereof would materially affect the
Company.   The Company relies upon a combination of trade
secrets, copyright, and trademark law, contractual arrangements and technical
means to protect its intellectual property rights.  GSE distributes
its software products under software license agreements that grant customers
nonexclusive licenses for the use of its products, which are
nontransferable.  Use of the licensed software is restricted to
designated computers at specified sites, unless the customer obtains a site
license of its use of the software.  Software and hardware security
measures are also employed to prevent unauthorized use of the Company’s
software, and the licensed software is subject to terms and conditions
prohibiting unauthorized reproduction of the software.
  The
Company previously held several U.S. patents that were issued in the 1996
timeframe, none of which (individually or collectively) had a significant role
in the Company’s current business operations.  The Company elected to
not renew or extend those patents and, at present, does not own any
patents.  In accordance with Title 35 U.S. Code Section 154, patents
have a duration of 20 years from the filing date of the application, subject to
any statutory extension, provided they are properly maintained.  The
Company believes that all of the Company’s trademarks (especially those that use
the phrase "GSE Systems") are valid and will have an unlimited duration as long
as they are adequately protected and sufficiently used.  The Company’s
licenses are perpetual in nature and will have an unlimited duration as long as
they are adequately protected and the parties adhere to the material terms and
conditions.
  GSE has
eleven registered U.S. trademarks:  RETACT®, GSE Systems®, THOR®,
OpenSim®, SmartTutor®, SimSuite Pro®, ESmart®, GAARDS®, Openexec®,
REMITS-Real-Time Emergency Management Interactive Training System® and
SimExec®   Some of these trademarks have also been registered in
foreign countries.  The Company also claims trademark rights to
GFLOW+TM, GLOGIC+TM, GCONTROL+TM, GPower+TM, SimSuite PowerTM, eXtreme I/STM, RACSTM,
PEGASUS Plant Surveillance and Diagnosis SystemTM, SIMONTM, BRUSTM, Sens BaseTM,
Vista PINTM, and Java Application and Development Enviroment
(JADE)TM.
  In
addition, the Company maintains federal statutory copyright protection with
respect to its software programs and products, has registered copyrights for
some of the documentation and manuals related to these programs, and maintains
trade secret protection on its software products.
 
 17





Despite
these protections, the Company cannot be sure that it has protected or will be
able to protect its intellectual property adequately, that the unauthorized
disclosure or use of its intellectual property will be prevented, that others
have not or will not develop similar technology independently, or, to the extent
it owns any patents in the future, that others have not or will not be able
to design around those patents.   Furthermore, the laws of
certain countries in which the Company’s products are sold do not protect its
products and intellectual property rights to the same extent as the laws of the
United States.








Industries
Served.





The following chart illustrates the
approximate percentage of the Company's 2007, 2006, and 2005 consolidated
revenue by industries served:







2007
              
              2006
              
              2005Nuclear
      power industry
              45%
              
              60%
              
              83%Fossil
      power industry
              
              20%
              
              18%
              
              14%Training
      and education industry
              31%
              
              21%
              
              -Other
              
              
              4%
              
              1%
              
              3%Total
              
              100%
              
              100%
              
              100%
   Contract Backlog.





The Company does not reflect an order
in backlog until it has received a contract that specifies the terms and
milestone delivery dates. As of December 31, 2007, the Company’s aggregate
contract backlog totaled approximately $24.6 million (including $1.1 million for
the ESA contract) of which approximately $15.9 million or 65% is expected to be
converted to revenue by December 31, 2008.As of December
31, 2006, the Company’s aggregate contract backlog totaled approximately $18.5
million.








Employees.





As of December 31, 2007, the Company
had 153 employees as compared to 135 employees at December 31,
2006.










ITEM 1A.  RISK
FACTORS.





The
following discussion of risk factors contains “forward-looking statements,” as
discussed on page 3 of this Annual Report on Form 10-K.  These risk
factors may be important to understanding any statement in this Annual Report on
Form 10-K or elsewhere.  The Company believes that the following risk
factors may cause the market price for its common stock to fluctuate, perhaps
significantly. In addition, in recent years the stock market in general, and the
shares of technology companies in particular, have experienced extreme price
fluctuations.  The Company’s common stock has also experienced a
relatively low trading volume, making it further susceptible to extreme price
fluctuations. The following information should be read in conjunction with Item
7, Management’s Discussion and Analysis of Financial Condition and Results of
Operations and the consolidated financial statements and related notes under
Item 8, Financial Statements and Supplementary Data.
   18





We
routinely encounter and address risks, some of which may cause our future
results to be different, sometimes materially, than we presently
anticipate.  Discussion about important operational risks that we
encounter can be found in Item 1, Business and Item 7, Management’s Discussion
and Analysis of Financial Condition and Results of Operations.  We
have described certain important strategic risks below.  Our reactions
as well as our competitors’ reactions to material future developments may affect
our future results.
 
 The
Company’s global growth is subject to a number of economic and political
risks.
 
 The
Company conducts its operations in Europe, Asia and the Middle
East.  Global economic developments affect businesses such as GSE and
the Company’s operations are subject to the effects of global competition. The
Company’s global business is affected by local economic environments, including
inflation, recession and currency volatility.  Political changes, some
of which may be disruptive, can interfere with the Company’s supply chain, its
customers and all of its activities in a particular location. While some of
these risks can be hedged using derivatives or other financial instruments and
some are insurable, such attempts to mitigate these risks are costly and not
always successful.
 
 The
Company’s expense levels are based upon its expectations as to future revenue,
so it may be unable to adjust spending to compensate for a revenue
shortfall.  Accordingly, any revenue shortfall would likely have a
disproportionate effect on the Company’s operating results.
 
 The
Company’s revenue was $31.9 million, $27.5 million, and $22.0 million for the
years ended December 31, 2007, 2006 and 2005, respectively.  The
Company’s operating income (loss) was $2.2 million, $2.1 million and ($4.7
million) for the years ended December 31, 2007, 2006, and 2005,
respectively.  The Company’s operating results have fluctuated in the
past and may fluctuate significantly in the future as a result of a variety of
factors, including purchasing patterns, timing of new products and enhancements
by the Company and its competitors, and fluctuating foreign economic
conditions.  Since the Company’s expense levels are based in part on
its expectations as to future revenue and includes certain fixed costs, the
Company may be unable to adjust spending in a timely manner to compensate for
any revenue shortfall and such revenue shortfalls would likely have a
disproportionate adverse effect on operating results.


Risk of International Sales and
Operations.





Sales of products and services to end
users outside the United States accounted for approximately 71% of the Company’s
consolidated revenue in 2007, 74% of consolidated revenue in 2006, and 63% of
consolidated revenue in 2005.  The Company anticipates that
international sales and services will continue to account for a significant
portion of its revenue in the foreseeable future.  As a result, the
Company may be subject to certain risks, including risks associated with the
application and imposition of protective legislation and regulations relating to
import or export (including export of high technology products) or otherwise
resulting from trade or foreign policy and risks associated with exchange rate
fluctuations.  Additional risks include potentially adverse tax
consequences, tariffs, quotas and other barriers, potential difficulties
involving the Company’s strategic alliances and managing foreign sales agents or
representatives and potential difficulties in accounts receivable
collection.  The Company currently sells products and provides
services to customers in emerging market economies such as the United Arab
Emirates (31% and 21% of the Company’s consolidated revenue in 2007 and 2006,
respectively, but none in 2005) and Russia (9% and 12% of the Company’s
consolidated revenue in 2007 and 2006, respectively, but none in
2005).  Although end users in the Ukraine accounted for 4%, 8%, and
18% of the Company’s consolidated revenue in 2007, 2006, and 2005, respectively,
GSE’s customer for these projects was Battelle’s Pacific Northwest National
Laboratory, which is the purchasing agent for the U.S. Department of Energy
("DOE").  The DOE provides funding for various projects in Eastern and
Central Europe.  Accordingly, the Company is not subject to the
political and financial risks that are normally faced when doing business in the
Ukraine.  The Company has taken steps designed to reduce the
additional risks associated with doing business in these countries, but the
Company believes that such risks may still exist and include, among others,
general political and economic instability, lack of currency convertibility, as
well as uncertainty with respect to the efficacy of applicable legal
systems.  There can be no assurance that these and other factors will
not have a material adverse effect on the Company’s business, financial
condition or results of operations.





For the year ended December 31, 2007,
one customer provided a substantial portion of the Company’s consolidated
revenue. The Company will not generate the same level of revenue from this
customer in future periods, and there is no guarantee that the Company will
replace this revenue from other customers.  The loss of this revenue
would cause a material adverse effect upon the Company’s future revenue and
results of operations.


19







For the
year ended December 31, 2007, the Emirates Simulation Academy, LLC (UAE)
provided 31% of the Company’s consolidated 2007 revenue (21% in 2006 and none in
2005).  The Company will not generate comparable revenue from this
customer in future periods and may not be able to replace this revenue from
other customers, thus materially and adversely affecting the Company’s revenue
and results of operations.





The Company’s business is largely
dependent on sales to the nuclear power industry.  Any disruption in
this industry would have a material adverse effect upon the Company’s
revenue.





In 2007, 45% of GSE’s revenue was from
customers in the nuclear power industry (60% in 2006 and 83% in
2005).  The Company will continue to derive a significant portion of
its revenue from customers in the nuclear power industry for the foreseeable
future.  The Company’s ability to supply nuclear power plant
simulators and related products and services is dependent on the continued
operation of nuclear power plants and, to a lesser extent, on the construction
of new nuclear power plants.  A wide range of factors affect the
continued operation and construction of nuclear power plants, including the
political and regulatory environment, the availability and cost of alternative
means of power generation, the occurrence of future nuclear incidents, and
general economic conditions.





The Company expects to finalize
a new line of credit agreement with Bank of America by March 31,
2008.  This agreement will impose significant operating and financial
restrictions, which may prevent the Company from capitalizing on business
opportunities.





GSE’s
line of credit agreement with Bank of America will impose significant operating
and financial restrictions. These restrictions will affect, and in certain
cases limit, among other things, the Company’s ability to:





 ̈
            incur
      additional indebtedness and liens;





 ̈
            make
      capital expenditures;





 ̈
            make
      investments and acquisitions;





 ̈
            consolidate,
      merge or sell all or substantially all of its
  assets.





There can
be no assurance that these restrictions will not adversely affect the Company’s
ability to finance its future operations or capital needs or to engage in other
business activities that may be in the interest of stockholders.








The Company is dependent on product
innovation and research and development, which costs are incurred prior to
revenue for new products and improvements.





The Company believes that its success
will depend in large part on its ability to maintain and enhance its current
product line, develop new products, maintain technological competitiveness and
meet an expanding range of customer needs.  The Company's product
development activities are aimed at the development and expansion of its library
of software modeling tools, the improvement of its display systems and
workstation technologies, and the advancement and upgrading of its simulation
technology. The life cycles for software modeling tools, graphical user
interfaces, and simulation technology are variable and largely determined by
competitive pressures. Consequently, the Company will need to continue to make
significant investments in research and development to enhance and expand its
capabilities in these areas and to maintain its competitive
advantage.


20




The Company relies upon its
intellectual property rights for the success of its business; however, the steps
it has taken to protect its intellectual property may be
inadequate.





Although the Company believes that
factors such as the technological and creative skills of its personnel, new
product developments, frequent product enhancements and reliable product
maintenance are important to establishing and maintaining a technological
leadership position, the Company's business depends, in part, on its
intellectual property rights in its proprietary technology and
information.  The Company relies upon a combination of trade secret,
copyright, and trademark law, contractual arrangements and technical means
to protect its intellectual property rights.  The Company enters into
confidentiality agreements with its employees, consultants, joint venture and
alliance partners, customers and other third parties that are granted access to
its proprietary information, and limits access to and distribution of its
proprietary information.  There can be no assurance, however, that the
Company has protected or will be able to protect its proprietary technology and
information adequately, that the unauthorized disclosure or use of the Company's
proprietary information will be prevented, that others have not or will not
develop similar technology or information independently, or, to the extent the
Company owns any patents in the future, that others have not or will not be able
to design around those future patents. Furthermore, the laws of certain
countries in which the Company's products are sold do not protect the Company's
products and intellectual property rights to the same extent as the laws of the
United States.





The industries in which GSE operates
are highly competitive.  This competition may prevent the Company from
raising prices at the same pace as its costs increase.





The Company's businesses operate in
highly competitive environments with both domestic and foreign competitors, many
of whom have substantially greater financial, marketing and other resources than
the Company. The principal factors affecting competition include price,
technological proficiency, ease of system configuration, product reliability,
applications expertise, engineering support, local presence and financial
stability. The Company believes that competition in the simulation fields may
further intensify in the future as a result of advances in technology,
consolidations and/or strategic alliances among competitors, increased costs
required to develop new technology and the increasing importance of software
content in systems and products.  As the Company’s business has a
significant international component, changes in the value of the dollar could
adversely affect the Company's ability to compete internationally.




GSE may pursue new acquisitions and
joint ventures, and any of these transactions could adversely affect its
operating results or result in increased costs or related
issues.





The Company intends to pursue new
acquisitions and joint ventures, a pursuit which could consume substantial time
and resources. Identifying appropriate acquisition candidates and negotiating
and consummating acquisitions can be a lengthy and costly process. The Company
may also encounter substantial unanticipated costs or other related issues such
as compliance with new regulations and regulatory schemes, additional oversight,
elimination of redundancy, and increased employee benefit costs associated with
the acquired businesses. The risks inherent in this strategy could have an
adverse impact on the Company’s results of operation or financial
condition.


21





The nuclear power industry, the
Company’s largest customer group, is associated with a number of hazards which
could create significant liabilities for the Company.





The Company’s business could expose it
to third party claims with respect to product, environmental and other similar
liabilities. Although the Company has sought to protect itself from these
potential liabilities through a variety of legal and contractual provisions as
well as through liability insurance, the effectiveness of such protections has
not been fully tested. Certain of the Company’s products and services are used
by the nuclear power industry primarily in operator
training.  Although the Company’s contracts for such products and
services typically contain provisions designed to protect the Company from
potential liabilities associated with such use, there can be no assurance that
the Company would not be materially adversely affected by claims or actions
which may potentially arise.





The Company, as a 10% owner of ESA,
has provided a partial guarantee totaling $1.2 million for the credit facility
thatUnion National
Bank has extended
to ESA. ESA is a start-up entity; if it is unable to generate sufficient cash
flow from operations and defaults on its credit facility, GSE may have to
provide up to $1.2 million toUnion National Bank to cover ESA’s
obligations.





In May
2007, the Company deposited $1.2 million into a restricted, interest-bearing
account at Union National Bank (“UNB”) in the United Arab Emirates as a partial
guarantee for the $11.8 million credit facility that UNB has extended to ESA.
The guarantee will be in place until the expiration of the ESA credit facility
on December 31, 2014 or earlier if ESA pays down and terminates the facility.
Both of the other two owners of ESA, Al Qudra Holding PJSC and the Centre of
Excellence for Applied Research and Training, both located in the United Arab
Emirates, have each provided to UNB a bank guarantee for 100% of the $11.8
million ESA credit facility. In the event that ESA should default upon their UNB
loan, UNB can utilize all or a portion of the guarantees that the three owners
have provided to cover ESA’s outstanding borrowings against the credit facility
and accrued interest payable. Thus, if such a default were to occur, GSE may
incur a loss of up to $1.2 million.




In January 2006, the Company received
a $15.1 million contract from ESA to supply five simulators and an integrated
training program.A $1.7
million change order was received from ESA in late 2007 increasing the total
order value to $16.8 million.Under the terms of the contract, the
Company provided a $2.1 million performance bond to ESA that will remain
outstanding until October 31, 2008.





The
Company has provided a cash-collateralized standby letter of credit to ESA which
can be drawn upon by ESA in the event the Company fails to cure a material
breach of the contract within 30 days of receiving written notice from ESA
regarding the nature of the breach.   Although the contract is
expected to be complete in early 2008 and no such material breach is expected,
if ESA were to draw upon the standby letter of credit, GSE would incur a loss of
up to $2.1 million.




The Company accounts for its
investment in ESA using the equity method.  Accordingly, the Company
will record 10% of ESA’s net income (loss) as an adjustment of its
investment.




As ESA is
a start-up entity, it is likely that it will incur net losses for some period of
time.  Under the equity method, the Company is required to record 10%
of such losses as a charge to other income (expense) and as a reduction of its
investment in ESA; in 2007 the Company recorded an equity loss of
$54,000.  At December 31, 2007 the Company’s investment in ESA totaled
$445,000.  Depending on ESA’s future performance, the Company may be
required to write off a portion or all of this investment.




The
Company is subject to a wide variety of laws and
regulations.




The Company’s businesses are subject to
regulation by U.S. federal and state laws and foreign laws, regulations and
policies. Changes to laws or regulations may require the Company to modify its
business objectives if existing practices become more restricted, subject to
escalating costs or prohibited outright. Particular risks include regulatory
risks arising from federal laws, such as laws regarding export of sensitive
technologies or technical information.  The Company’s business and the
industries in which it operates are also at time s being
reviewed or investigated by regulators, which could lead to enforcement actions,
fines and penalties or the assertion of private litigation claims and
damages.




22






ITEM 1B.  UNRESOLVED STAFF
COMMENTS.





None.








ITEM 2.   PROPERTIES.





The Company is headquartered in a
facility in Baltimore, Maryland (approximately 26,000 square feet). The lease
for this facility expires on July 31, 2008.  The Company has entered
into a new lease for its headquarters commencing on August 1, 2008 for a
facility in Eldersburg, Maryland (approximately 32,000 square
feet).





In addition, the Company leases office
space domestically in St. Marys and Atlanta, Georgia  and Tarrytown,
New York and internationally in Beijing, China and Nyköping,
Sweden.  The Company leases these facilities for terms ending between
2008 and 2012.





In October 2005, the Company relocated
its Maryland operations from its facility in Columbia to the Baltimore facility
and signed an “Assignment of Lease and Amendment to Lease” that assigned and
transferred to another tenant (the “assignee”) the Company’s rights, title and
interest in its Columbia, Maryland facility lease.  The assignee’s
obligation to pay rent under the Lease began on February 1, 2006.  The
Company remains fully liable for the payment of all rent and for the performance
of all obligations under the lease through the scheduled expiration of the
lease, May 31, 2008, should the assignee default on its
obligations.








ITEM 3.  LEGAL
PROCEEDINGS.





The Company and its subsidiaries are
from time to time involved in ordinary routine litigation incidental to the
conduct of its business. The Company and its subsidiaries are not a party to,
and its property is not the subject of, any material pending legal proceedings
that, in the opinion of management, are likely to have a material adverse effect
on the Company’s business, financial condition or results of
operations.







23


ITEM 4.  SUBMISSION OF MATTERS TO A
VOTE OF SECURITY HOLDERS.
 
 On December 13, 2007, the Company held
a special meeting of stockholders.  At that meeting, the following
matters were voted upon:
   Proposal
              
              For
              
              Against
              
              Abstain
              
              Total1)
              To
      approve the Company's secondamended
      and restated bylaws
              
              10,477,505
              
              65,217
              
              21,720
              
              10,564,4422)
              To
      approve the Company's fourthamended
      and restated certificate ofincorporation
              
              10,271,433
              
              270,879
              
              22,130
              
              10,564,4423)
              To
      approve the Company's1995
      Long-Term Incentive Plan (asamended
      and restated, effectiveSeptember
      25, 2007
              
              7,321,219
              
              3,234,531
              
              8,692
              
              10,564,442





PART II








ITEM 5.  MARKET FOR REGISTRANT'S
COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY
SECURITIES.





The Company’s common stock is listed on
the American Stock Exchange, where it trades under the symbol
“GVP”.  The following table sets forth, for the periods indicated, the
high and low sale prices for the Company’s common stock reported by the American
Stock Exchange for each full quarterly period within the two most recent fiscal
years:








24





2007Quarter
            
            High
            
            LowFirst
            
            $   8.42
            
            $
    5.82Second
            
            $   7.55
            
            $
    6.17Third
            
            $   7.41
            
            $
    6.15Fourth
            
            $
      12.00
            
            $
    6.752006Quarter
            
            High
            
            LowFirst
            
            $   1.90
            
            $
    1.30Second
            
            $   4.56
            
            $
    1.70Third
            
            $   4.23
            
            $
    3.22Fourth
            
            $   6.99
            
            $
    3.20


The following table sets forth the equity
compensation plan information for the year ended December 31, 2007:


Number
      of SecuritiesNumber
      of Securities to
              Weighted
      Average
              Remaining
      Available forbe
      Issued Upon Exercise
              Exercise
      Price of
              Future
      Issuance Under Equityof
      Outstanding Options,
              Outstanding
      Options,
              Compensation
      Plans (ExcludingWarrants
      and Rights
              Warrants
      and Rights
              Securities
      Reflected in Column (a)Plan
      category
              (a)
              (b)
              (c)Equity
      compensation plans approved by security holders
              1,178,254
              $2.33
              1,346,795Equity
      compensation plans not approved by security holders
              --
              $
      --
              --Total
              1,178,254
              $2.33
              1,346,795


There
were approximately 95 holders of record of the common stock as of December 31,
2007. The Company has never declared or paid a cash dividend on its common
stock.  The Company currently intends to retain future earnings to
finance the growth and development of its business and, therefore, does not
anticipate paying any cash dividends in the foreseeable future on its common
stock.


25


At a
special shareholder’s meeting on December 13, 2007, the Company’s shareholders
approved an amendment to the Certificate of Incorporation increasing GSE’s
authorized common stock by 12 million shares to a total of 30 million
shares.





In
December 2001, the Company issued to ManTech International Corp. 39,000 shares
of convertible preferred stock which accrued dividends at an annual rate of 6%
payable quarterly. ManTech elected to convert the preferred stock to common
stock in October 2003. At the date of the conversion, the Company’s credit
facility restricted the Company from paying any dividends on the preferred
stock. The unpaid dividends accrued interest at 6% per
annum.   In 2007, the Company paid the total accrued dividends to
ManTech of $316,000 and the accrued interest of $89,000.





The Company believes factors such as
quarterly fluctuations in results of operations and announcements of new
products by the Company or by its competitors may cause the market price of the
common stock to fluctuate, perhaps significantly.  In addition, in
recent years the stock market in general, and the shares of technology companies
in particular, have experienced extreme price fluctuations.  The
Company’s common stock has also experienced a relatively low trading volume,
making it further susceptible to extreme price fluctuations.  These
factors may adversely affect the market price of the Company's common
stock.





On February 28, 2006, the Company
raised $3.9 million, net of associated fees of $395,000, through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to “accredited investors”, as that term is used in
rules and regulations of the Securities and Exchange Commission.  The
Convertible Preferred Stockholders were entitled to an 8% cumulative dividend,
payable on a semiannual basis every June 30 and December 30.  In 2006,
the Company paid dividends totaling $279,000 to the preferred stockholders; in
2007 the Company paid dividends totaling $49,000. At any time after March 1,
2007, the Company had the right to convert the Preferred Stock into shares of
GSE common stock when the average of the current stock price during the twenty
trading days immediately prior to the date of such conversion exceeded 200% of
the Series A Conversion Price.  On March 7, 2007, the Company sent
notice to the holders of the remaining 20,000 outstanding shares of its
Preferred Stock that the average current stock price for the prior twenty
trading days had exceeded 200% of the Conversion Price, and that the Company was
converting the outstanding Preferred Stock into common stock. The 20,000 shares
of Preferred Stock converted to 1,129,946 shares of GSE common
stock.  Prior to March 7, 2007, the holders of 22,500 shares of
Preferred Stock had already elected to convert their Preferred Stock into a
total of 1,271,187 shares of Common Stock; 8,580 shares of Preferred Stock were
converted in 2006, and 13,920 shares of Preferred Stock in 2007.





On June
22, 2007, the Company raised $9.2 million, net of associated fees of $768,000,
through the sale of 1,666,667 shares (the “Shares”) of its common stock, $.01
par value per share, by means of a private placement to selected institutional
investors.  Each investor received a five-year warrant to purchase GSE
common stock (the “Warrant Shares”) equal to 10% of the shares of common stock
that each investor purchased at an exercise price of $6.00 per share (the
“Warrants”).  In aggregate, the Company issued Warrants to purchase a
total of 166,667 shares of GSE common stock.







26


The
Company filed its registration statement on Form S-3 with the Securities and
Exchange Commission (the “Commission”) on July 16, 2007 covering the offer and
sale, from time to time, of the Shares, the Warrant Shares and shares of common
stock issuable upon exercise of warrants that may be issued as liquidated
damages under the terms of a certain registration rights agreement entered into
between the Company and the investors (the “Registration Rights Agreement”) in
connection with the private placement.  The Registration Statement
became effective on August 8, 2007 and, pursuant to the provisions of the
Registration Rights Agreement, the Company is obligated to use commercially
reasonable efforts to, after the date on which the Registration Statement
becomes effective, cause the Registration Statement to remain continuously
effective as to all Shares and Warrant Shares, other than for an aggregate of
more than 30 consecutive trading days or for more than an aggregate of 60
trading days in any 12-month period. In the event of a default of the foregoing
obligation, the Company will be required to issue to the investors, as
liquidated damages, on the date the foregoing default occurs and each monthly
anniversary thereafter, a number of warrants (on the same terms as the Warrants)
equal to 2% of the number of Shares then held by such investor, not to exceed
10% of the total number of Shares then held by such investor, and thereafter
cash, in an amount equal to 2% of the aggregate purchase price paid by the
investors, not to exceed 30% of the aggregate purchase price paid by the
investors.





The
Company paid the placement agent for the Shares and Warrants 6% of the gross
proceeds received by the Company from the offering ($600,000).  In
addition to the placement agent fee, the Company paid $168,000 of other
transaction fees related to the offering.





The
proceeds were used to pay down the Company’s line of credit and for other
working capital purposes.





The
following graph compares the Company’s cumulative total shareholder return since
January 1, 2002 through December 31, 2007 with that of the American Stock
Exchange- US & Foreign Index and a peer group index.  The Peer
Group consists of companies selected on a line-of-business basis and includes
Aspen Technology, Inc., GenSym Corporation and Honeywell
International.  GenSym was acquired by privately held Versata
Enterprises, Inc. on August 10, 2007.  The graph assumes an initial
investment of $100 on January 1, 2002 in our common stock and each
index.  There were no dividends declared or paid by the Company during
the five year period.  The Company has never paid a dividend on its
common stock.  The indices are re-weighted daily, using the market
capitalization on the previous tracking day.  The comparisons shown in
the graph below are based upon historical data.  The stock price
performance shown in the graph below is not necessarily indicative of, or
intended to forecast, the potential future performance of the Company’s common
stock.  The graph was prepared for the Company by Morningstar,
Inc.


27





12/31/2002
              12/31/2003
              12/31/2004
              12/31/2005
              12/30/2006
              12/29/2007GSE
      Systems, Inc.
              100.00
              171.43
              257.14
              118.10
              633.43
              975.24Peer
      Group Index
              100.00
              144.26
              155.41
              167.21
              207.73
              289.85Amex
      Market Index
              100.00
              136.11
              155.86
              171.89
              192.45
              216.06


Sales of
Unregistered Securities





The
Company’s sales of unregistered securities during the past three years are
described in Item 5 above.








ITEM 6.  SELECTED CONSOLIDATED
FINANCIAL DATA.





Historical consolidated results of
operations and balance sheet data presented below have been derived from the
historical financial statements of the Company.  This information
should be read in connection with the Company’s consolidated financial
statements.


28


(in thousands, except per
      share data)
              
              Years
      ended December 31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003Consolidated
      Statements of Operations:Contract
      revenue
              
              $
              31,900
              
              
              $
              27,502
              
              
              $
              21,950
              
              
              $
              29,514
              
              
              $
              25,019Cost
      of revenue
              
              
              22,217
              
              
              
              19,602
              
              
              
              18,603
              
              
              
              22,715
              
              
              
              19,175Gross
      profit
              
              
              9,683
              
              
              
              7,900
              
              
              
              3,347
              
              
              
              6,799
              
              
              
              5,844Operating
      expenses:Selling,
      general and administrative
              
              
              7,214
              
              
              
              4,929
              
              
              
              6,958
              
              
              
              5,543
              
              
              
              6,343Administrative
      charges from GP Strategies
              
              
              -
              
              
              
              685
              
              
              
              685
              
              
              
              974
              
              
              
              100Depreciation
              
              
              258
              
              
              
              186
              
              
              
              431
              
              
              
              280
              
              
              
              392Total
      operating expenses
              
              
              7,472
              
              
              
              5,800
              
              
              
              8,074
              
              
              
              6,797
              
              
              
              6,835Operating
      income (loss)
              
              
              2,211
              
              
              
              2,100
              
              
              
              (4,727
              )
              
              
              2
              
              
              
              (991
              )Interest
      expense, net
              
              
              (433
              )
              
              
              (764
              )
              
              
              (416
              )
              
              
              (176
              )
              
              
              (504
              )Loss
      on extinguishment of debt
              
              
              -
              
              
              
              (1,428
              )
              
              
              -
              
              
              
              -
              
              
              
              -Other
      income (expense), net
              
              
              (566
              )
              
              
              (105
              )
              
              
              497
              
              
              
              316
              
              
              
              (273
              )Income
      (loss) from continuing operationsbefore
      income taxes
              
              
              1,212
              
              
              
              (197
              )
              
              
              (4,646
              )
              
              
              142
              
              
              
              (1,768
              )Provision
      for income taxes
              
              
              43
              
              
              
              149
              
              
              
              149
              
              
              
              60
              
              
              
              93Income
      (loss) from continuing operations
              
              
              1,169
              
              
              
              (346
              )
              
              
              (4,795
              )
              
              
              82
              
              
              
              (1,861
              )Loss
      from discontinued operations,net
      of income taxes
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,409
              )Income
      (loss) on sale of discontinued operations,net
      of income taxes
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              36
              
              
              
              (262
              )Income
      (loss) from discontinued operations
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              36
              
              
              
              (1,671
              )Net
      income (loss)
              
              $
              1,169
              
              
              $
              (346
              )
              
              $
              (4,795
              )
              
              $
              118
              
              
              $
              (3,532
              )Basic
      income (loss) per common share (1) (2):Continuing
      operations
              
              $
              0.09
              
              
              $
              (0.07
              )
              
              $
              (0.53
              )
              
              $
              0.01
              
              
              $
              (0.61
              )Discontinued
      operations
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (0.26
              )Net
      income (loss)
              
              $
              0.09
              
              
              $
              (0.07
              )
              
              $
              (0.53
              )
              
              $
              0.01
              
              
              $
              (0.87
              )Diluted
      income (loss) per common share (1) (2):Continuing
      operations
              
              $
              0.08
              
              
              $
              (0.07
              )
              
              $
              (0.53
              )
              
              $
              0.01
              
              
              $
              (0.61
              )Discontinued
      operations
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (0.26
              )Net
      income (loss)
              
              $
              0.08
              
              
              $
              (0.07
              )
              
              $
              (0.53
              )
              
              $
              0.01
              
              
              $
              (0.87
              )Weighted
      average common shares outstanding:-Basic
              
              
              12,927
              
              
              
              9,539
              
              
              
              8,999
              
              
              
              8,950
              
              
              
              6,542-Diluted
              
              
              14,818
              
              
              
              9,539
              
              
              
              8,999
              
              
              
              9,055
              
              
              
              6,542As
      of December 31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003Balance
      Sheet data:Working
      capital (deficit)
              
              $
              14,711
              
              
              $
              1,463
              
              
              $
              (925
              )
              
              $
              2,175
              
              
              $
              2,130Total
      assets
              
              
              28,364
              
              
              
              18,448
              
              
              
              11,982
              
              
              
              14,228
              
              
              
              16,536Long-term
      liabilities
              
              
              695
              
              
              
              251
              
              
              
              1,567
              
              
              
              19
              
              
              
              34Stockholders'
      equity
              
              
              20,365
              
              
              
              7,361
              
              
              
              897
              
              
              
              5,945
              
              
              
              5,679(1) In
      2006, $279,000 preferred stock dividends were deducted from net loss to
      arrive at net loss attributed to common shareholders.In
      2007, $49,000 preferred stock dividends were deducted from net income to
      arrive at net income attributed to common shareholders.(2) In
      2003, $2,140,000 preferred stock dividends and benefical conversion
      premium were deducted from net loss to arrive at net lossattributed
      to common shareholders.
  29




ITEM 7. MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.





On June
21, 2005, the Board of Directors of GP Strategies Corporation (“GP Strategies”)
approved plans to spin-off its 57% interest in GSE through a special dividend to
the GP Strategies’ stockholders.  On September 30, 2005, the GP
Strategies’ stockholders received 0.283075 share of GSE common stock for each
share of GP Strategies common stock or Class B stock held on the record date of
September 19, 2005.  Following the spin-off, GP Strategies ceased to
have any ownership interest in GSE.  GP Strategies continued to
provide corporate support services to GSE, including accounting, finance, human
resources, legal, network support and tax pursuant to a Management Services
Agreement which expired on December 31, 2006.





On June
22, 2007, the Company raised $9.2 million, net of associated fees of $768,000,
through the sale of 1,666,667 shares (the “Shares”) of its common stock, $.01
par value per share, by means of a private placement to selected institutional
investors.  Each investor received a five-year warrant to purchase GSE
common stock (the “Warrant Shares”) equal to 10% of the shares of common stock
that each investor had purchased at an exercise price of $6.00 per share (the
“Warrants”).  In aggregate, the Company issued Warrants to purchase a
total of 166,667 shares of GSE common stock.





The
Company filed its registration statement on Form S-3 with the Securities and
Exchange Commission (the “Commission”) on July 16, 2007 covering the offer and
sale, from time to time, of the Shares, the Warrant Shares and shares of common
stock issuable upon exercise of warrants that may be issued as liquidated
damages under the terms of a certain registration rights agreement entered into
between the Company and the investors (the “Registration Rights Agreement”) in
connection with the private placement.  The Registration Statement
became effective on August 8, 2007 and, pursuant to the provisions of the
Registration Rights Agreement, the Company is obligated to use commercially
reasonable efforts to, after the date on which the Registration Statement
becomes effective, cause the Registration Statement to remain continuously
effective as to all Shares and Warrant Shares, other than for an aggregate of
more than 30 consecutive trading days or for more than an aggregate of 60
trading days in any 12-month period. In the event of a default of the foregoing
obligation, the Company will be required to issue to the investors, as
liquidated damages, on the date the foregoing default occurs and each monthly
anniversary thereafter, a number of warrants (on the same terms as the Warrants)
equal to 2% of the number of Shares then held by such investor, not to exceed
10% of the total number of Shares then held by such investor, and thereafter
cash, in an amount equal to 2% of the aggregate purchase price paid by the
investors, not to exceed 30% of the aggregate purchase price paid by the
investors.





At the
date of issuance, the fair value of the Warrants was $510,000 and the fair value
of the Shares was $9.5 million.   The fair value of the Warrants
and the Shares was determined by the use of the relative fair value method, in
which the $10.0 million gross proceeds was allocated based upon the fair values
of the Warrants, as determined by using the Black-Scholes Model, and the Shares,
as determined by the closing price of the common stock on the American Stock
Exchange on the date the transaction was closed.





The
Company paid the placement agent for the Shares and Warrants 6% of the gross
proceeds received by the Company from the offering ($600,000).  In
addition to the placement agent fee, the Company paid $168,000 of other
transaction fees related to the offering.





The
proceeds were used to pay down the Company’s line of credit and for other
working capital purposes.





30


Critical
Accounting Policies and Estimates.





As
further discussed in Note 2 to the consolidated financial statements, in
preparing the Company’s financial statements, management makes several estimates
and assumptions that affect the Company’s reported amounts of assets,
liabilities, revenues and expenses.  Those accounting estimates that
have the most significant impact on the Company’s operating results and place
the most significant demands on management's judgment are discussed below. For
all of these policies, management cautions that future events rarely develop
exactly as forecast, and the best estimates may require adjustment.





Revenue Recognition on Long-Term
Contracts.The
majority of the Company’s revenue is derived through the sale of uniquely
designed systems containing hardware, software and other materials under
fixed-price contracts.  In accordance with Statement of Position 81-1,
Accounting for Performance of
Construction-Type and Certain Production-Type Contracts, the revenue
under these fixed-price contracts is accounted for on the
percentage-of-completion method. This methodology recognizes revenue and
earnings aswork
progresses on the contract and is based on an estimate of the revenue and
earnings earned to date, less amounts recognized in prior
periods.  The Company bases its estimate of the degree of completion
of the contract by reviewing the relationship of costs incurred to date to the
expected total costs that will be incurred on the project. Estimated contract
earnings are reviewed and revised periodically as the work progresses, and the
cumulative effect of any change in estimate is recognized in the period in which
the change is identified. Estimated losses are charged against earnings in the
period such losses are identified.  The Company recognizes revenue
arising from contract claims either as income or as an offset against a
potential loss only when the amount of the claim can be estimated reliably and
realization is probable and there is a legal basis of the claim. There were no
claims outstanding as of December 31, 2007.





Uncertainties
inherent in the performance of contracts include labor availability and
productivity, material costs, change order scope and pricing, software
modification and customer acceptance issues. The reliability of these cost
estimates is critical to the Company’s revenue recognition as a significant
change in the estimates can cause the Company’s revenue and related margins to
change significantly from the amounts estimated in the early stages of the
project.





As the
Company recognizes revenue under the percentage-of-completion method, it
provides an accrual for estimated future warranty costs based on historical and
projected claims experience.  The Company’s long-term contracts
generally provide for a one-year warranty on parts, labor and any bug fixes as
it relates to software embedded in the systems.





The
Company’s system design contracts do not normally provide for “post customer
support service” (PCS) in terms of software upgrades, software enhancements or
telephone support.  In order to obtain PCS, the customers normally
must purchase a separate contract.  Such PCS arrangements are
generally for a one-year period renewable annually and include customer support,
unspecified software upgrades, and maintenance releases.  The Company
recognizes revenue from these contracts ratably over the life of the agreements
in accordance with Statement of Position 97-2, Software Revenue
Recognition.





Revenue
from the sale of software licenses which do not require significant
modifications or customization for the Company’s modeling tools are recognized
when the license agreement is signed, the license fee is fixed and determinable,
delivery has occurred, and collection is considered probable.


31


Revenue
for contracts with multiple elements are recognized in accordance with Emerging
Issues Task Force Issue 00-21, Accounting for Revenue Arrangements
with Multiple Deliverables.





Revenue
from certain consulting or training contracts is recognized on a
time-and-material basis.  For time-and-material type contracts,
revenue is recognized based on hours incurred at a contracted labor rate plus
expenses.





Capitalization of Computer Software
Development Costs.  In accordance with Statement of Financial
Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed, the Company
capitalizes computer software development costs incurred after technological
feasibility has been established, but prior to the release of the software
product for sale to customers.   Once the product is available to
be sold, the Company amortizes the costs, on a straight line method, over the
estimated useful life of the product, which normally ranges from three to five
years.  As of December 31, 2007, the Company has net capitalized
software development costs of $1.2 million.  On an annual basis, and
more frequently as conditions indicate, the Company assesses the recovery of the
unamortized software computer costs by estimating the net undiscounted cash
flows expected to be generated by the sale of the product. If the undiscounted
cash flows are not sufficient to recover the unamortized software costs the
Company will write-down the investment to its estimated fair value based on
future discounted cash flows. The excess of any unamortized computer software
costs over the related net realizable value is written down and charged to
operations.  Significant changes in the sales projections could result
in an impairment with respect to the capitalized software that is reported on
the Company’s consolidated balance sheet.





Deferred Income Tax Valuation
Allowance.  Deferred income taxes arise from temporary
differences between the tax bases of assets and liabilities and their reported
amounts in the financial statements. As required by SFAS No. 109 Accounting for Income Taxes,
management makes a regular assessment of the realizability of the Company’s
deferred tax assets.  In making this assessment, management considers
whether it is more likely than not that some or all of the deferred tax assets
will not be realized.  The ultimate realization of deferred tax assets
is dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible.  Management
considers the scheduled reversal of deferred tax liabilities and projected
future taxable income of the Company in making this assessment.  A
valuation allowance is recorded to reduce the total deferred income tax asset to
its realizable value.  As of December 31, 2007, the Company’s largest
deferred tax asset related to a U.S. net operating loss carryforward of $17.2
million which expires in various amounts between 2017 and 2025. The amount of
U.S. loss carryforward which can be used by the Company each year is limited due
to changes in the Company’s ownership which occurred in 2003.  Thus, a
portion of the Company’s loss carryforward may expire unutilized. We believe
that the Company will achieve profitable operations in future years that will
enable the Company to recover the benefit of its net deferred tax
assets.  However, the Company presently does not have sufficient
objective evidence to support management’s belief, and accordingly, the Company
has established an $8.9 million valuation allowance for its net deferred tax
assets.








Results of Operations.





The following table sets forth the
results of operations for the periods presented expressed in thousands of
dollars and as a percentage of contract revenue.


32


(in
      thousands)
              
              Years ended December
      31,2007
              
              
              %
              
              
              2006
              
              
              %
              
              
              2005
              
              
              %Contract
      revenue
              
              $
              31,900
              
              
              
              100.0
              %
              
              $
              27,502
              
              
              
              100.0
              %
              
              $
              21,950
              
              
              
              100.0
              %Cost
      of revenue
              
              
              22,217
              
              
              
              69.6
              %
              
              
              19,602
              
              
              
              71.3
              %
              
              
              18,603
              
              
              
              84.7
              %Gross
      profit
              
              
              9,683
              
              
              
              30.4
              %
              
              
              7,900
              
              
              
              28.7
              %
              
              
              3,347
              
              
              
              15.3
              %Operating
      expenses:Selling,
      general and administrative
              
              
              7,214
              
              
              
              22.6
              %
              
              
              4,929
              
              
              
              17.9
              %
              
              
              6,958
              
              
              
              31.7
              %Administrative
      charges from GP Strategies
              
              
              -
              
              
              
              0.0
              %
              
              
              685
              
              
              
              2.5
              %
              
              
              685
              
              
              
              3.1
              %Depreciation
              
              
              258
              
              
              
              0.8
              %
              
              
              186
              
              
              
              0.7
              %
              
              
              431
              
              
              
              2.0
              %Total
      operating expenses
              
              
              7,472
              
              
              
              23.4
              %
              
              
              5,800
              
              
              
              21.1
              %
              
              
              8,074
              
              
              
              36.8
              %Operating
      income (loss)
              
              
              2,211
              
              
              
              7.0
              %
              
              
              2,100
              
              
              
              7.6
              %
              
              
              (4,727
              )
              
              
              (21.5
              )%Interest
      expense, net
              
              
              (433
              )
              
              
              (1.4
              )%
              
              
              (764
              )
              
              
              (2.8
              )%
              
              
              (416
              )
              
              
              (1.9
              )%Loss
      on extinguishment of debt
              
              
              -
              
              
              
              0.0
              %
              
              
              (1,428
              )
              
              
              (5.2
              )%
              
              
              -
              
              
              
              0.0
              %Other
      income (expense), net
              
              
              (566
              )
              
              
              (1.8
              )%
              
              
              (105
              )
              
              
              (0.3
              )%
              
              
              497
              
              
              
              2.3
              %Income
      (loss) before income taxes
              
              
              1,212
              
              
              
              3.8
              %
              
              
              (197
              )
              
              
              (0.7
              )%
              
              
              (4,646
              )
              
              
              (21.1
              )%Provision
      for income taxes
              
              
              43
              
              
              
              0.1
              %
              
              
              149
              
              
              
              0.6
              %
              
              
              149
              
              
              
              0.7
              %Net
      income (loss)
              
              $
              1,169
              
              
              
              3.7
              %
              
              $
              (346
              )
              
              
              (1.3
              )%
              
              $
              (4,795
              )
              
              
              (21.8
              )%


Comparison of the Years Ended
December 31, 2007 to December 31, 2006.








Contract
Revenue.  For the year ended December 31, 2007, contract
revenue totaled $31.9 million, a 16.0% increase from the $27.5 million for the
year ended December 31, 2007.  The increase is mainly attributable to
the $15.1 million ESA contract received in January 2006.  A $1.7
million change order was received from ESA in late 2007 increasing the total
order value to $16.8 million.  For the twelve months ended December
31, 2007 and 2006, the Company recognized $9.9 million and $5.7 million,
respectively, of contract revenue on this project.  The ESA contract
is expected to be complete in early 2008.  Total orders received in
2007 were $37.8 million versus $33.5 million in 2006.  At December 31,
2007, the Company’s backlog was approximately $24.6 million, of which $1.1
million related to the ESA contract.





Gross
Profit.  Gross profit totaled $9.7 million for the year ended
December 31, 2007 versus $7.9 million for the year ended December 31,
2006.  As a percentage of revenue, gross profit increased from 28.7%
for the twelve months ended December 31, 2006 to 30.4% for the twelve months
ended December, 31 2007.   The increase in gross profit
percentage mainly reflects the higher proportion of revenue from the ESA project
in 2007.





Selling, General and Administrative
Expenses.  Selling, general and administrative (“SG&A”)
expenses increased 46.4% from $4.9 million for the year ended December 31, 2006
to $7.2 million for the year ended December 31, 2007.  The increase
reflects the following spending variances:





 ̈
            Business
      development and marketing costs increased from $2.1 million for the year
      ended December 31, 2006 to $2.6 million in the year ended December 31,
      2007.  In the latter part of 2006, the Company added additional
      business development personnel, plus the Company incurred higher bidding
      and proposal costs in 2007.


33




 ̈
            The
      Company’s general and administrative expenses totaled $4.1 million in the
      year ended December 31, 2007, which was 76.1% higher than the $2.3 million
      incurred in 2006.  The increase is due to the
      following:





o
            The
      Management Services Agreement with GP Strategies was terminated on
      December 31, 2006.  Under this agreement, General Physics (a GP
      Strategies subsidiary) provided corporate support services, including
      accounting, finance, human resources, legal, and network
      support.  In conjunction with the reinstatement of these
      corporate services in-house, the Company hired several personnel,
      implemented a new financial system and contracted with outside vendors to
      provide payroll services and IT support and hosting
    services.





o
            In
      February 2007, the Board of Directors approved a new director compensation
      plan.  In 2006, only the Audit Committee members received
      compensation; in 2007 all non-employee directors received
      compensation.  In addition, the independent directors were
      awarded 10,000 stock options each on February 6, 2007.  The
      options were valued using the Black-Scholes method, and the cost is being
      amortized over the three year vesting period.  Accordingly,
      total director compensation expense increased by $202,000 in 2007 as
      compared to 2006.





o
            The
      Company established a two-man Advisory Committee to the Board of Directors
      which met once in the first quarter 2007. The Advisory Committee members
      are not affiliated with the Company or any of its subsidiaries. The
      Advisory Committee members receive a fee of $7,500 for each meeting that
      they attend.





o
            In
      May 2006, the Company hired an outside investor relations consulting
      firm.  The firm received a monthly fee of $3,500 and a total of
      50,000 shares of GSE common stock, with 2,778 shares earned as of the last
      day of each month during the 18-month consulting period.  A
      certificate representing all 50,000 shares of GSE common stock was
      delivered to the investor relations consulting firm in October
      2007.  The fair value of the shares earned was determined using
      the closing AMEX price as of the last day of each month.  In
      November 2007, this agreement was extended through April 2009, with a
      monthly fee of $5,000 and a total of 25,000 shares of GSE common stock,
      with 1,388 shares earned as of the last day of each month during the
      18-month consulting period.   Total compensation paid to
      the investor relations consulting firm, including the value of the earned
      shares of common stock, increased by $148,000 in 2007 versus
      2006.





o
            In
      2007, the Company hired an independent accounting firm to perform a study
      to determine whether an even triggering IRS Code Section 382 had
      occurred.  Section 382 limits the amount of income that may be
      offset by net operating losses after an ownership change. The Company
      incurred $137,000 of expense related to this study and related costs in
      2007.





o
            As
      of June 30, 2007, the Company’s market capitalization exceeded $75
      million.  The Company hired an internal audit manager and hired
      its independent registered public accountants to perform an audit of the
      Company’s internal controls over financial reporting as of December 31,
      2007 as required by the Sarbanes-Oxley Act of 2002 (“SOX”).  No
      such audit of the Company’s internal controls over financial reporting was
      required in 2006.  The Company incurred a total of $228,000 of
      expense related to SOX compliance in
2007.


34




 ̈
            Gross
      spending on software product development (“development”) totaled $1.2
      million in the year ended December 31, 2007 as compared to $871,000 in
      2006.  For the year ended December 31, 2007, the Company
      expensed $514,000 and capitalized $673,000 of its development spending
      while in the year ended December 31, 2006, the Company expensed $538,000
      and capitalized $333,000 of its development spending.  The
      Company’s capitalized development expenditures in 2007 were related to the
      development of a new graphic user interface (“GUI”) for THEATRe, the
      replacement of the GUI for SimSuite Pro with JADE Designer, and the
      addition of new features to JADE Topmeret and Opensim. The Company
      anticipates that its total gross development spending in 2008 will
      approximate $1.1 million.





Administrative Charges from GP
Strategies.  As noted above, the Company terminated its
Management Services Agreement with GP Strategies on December 31,
2006.  The Company was charged $685,000 by GP Strategies in the twelve
months ended December 31, 2006.





Depreciation.  For
the year ended December 31, 2007 and 2006, depreciation expense totaled $258,000
and $186,000, respectively.  The increase in depreciation expense
reflects an increase in capital spending in the year ended December 31, 2007 as
compared to the year ended December 31, 2006, $778,000 vs. $185,000,
respectively.  Approximately 50% of the capital spending in 2007 was
for furniture and computer equipment for the training centers that the Company
is establishing at Georgia Tech University and Strathclyde University; the
balance was for computers, printers, servers and software.





Operating
Income.  The Company had operating income of $2.2 million and
$2.1 million in the years ended December 31, 2007 and 2006,
respectively.  As a percentage of revenue, operating income decreased
from 7.6% of revenue in 2006 to 7.0% in 2007.  The decrease in
operating income as a percentage of revenue was due to the factors outlined
above.





Interest Expense,
Net.  For the year ended December 31, 2007, net interest
expense totaled $433,000 as compared to net interest expense for the year ended
December 31, 2006 of $764,000.





In June
2007, using the proceeds from the Company’s June 2007 common stock and warrant
transaction, the Company paid off the outstanding balance of its line of credit
and did not borrow against the line of credit for the balance of
2007.  For the years ended December 31, 2007 and 2006, interest
expense on credit facility borrowings totaled $107,000 and $264,000,
respectively.





Amortization
of deferred financing costs related to the Company’s line of credit increased
from $200,000 for the year ended December 31, 2006 to $231,000 for the year
ended December 31, 2007.  The Company entered into its $5.0 million
line of credit with Laurus Master Fund, Ltd. in March 2006.





Amortization
of the cost of the warrants issued to Laurus in conjunction with the credit
facility totaled $302,000 in 2007 versus $251,000 in 2006.





For the
year ended December 31, 2006, the Company incurred interest expense of $26,000
on the Dolphin Note and original issue discount accretion related to the Dolphin
Note and GSE Warrant of $58,000.  The Company paid off the Dolphin
Note in conjunction with the preferred stock transaction that was completed in
February 2006.


35


The
Company has approximately $2.9 million of cash in Certificates of Deposit that
are being used as collateral for six performance bonds.  The Company
recognized $104,000 of interest income on these Certificates of Deposit in the
year ended December 31, 2007.  In the year ended December 31, 2006,
the Company recognized $56,000 of interest income on its Certificates of
Deposit.





Interest
income earned on short-term investments of the Company’s operating cash totaled
$96,000 for the year ended December 31, 2007.





The
Company deposited $1.2 million into a restricted, interest-bearing account at
the Union National Bank in the United Arab Emirates as a partial guarantee for
ESA’s credit facility.  The Company earned $36,000 of interest income
on this account in 2007.





Interest recorded
on the preferred dividends payable to ManTech was $9,000 for the year ended
December 31, 2007 and $20,000 for the year ended December 31, 2006.





Other
miscellaneous interest expense, net totaled $20,000 and $1,000 respectively, in
the years ended December 31, 2007 and 2006.





Loss on Extinguishment of
Debt.  On February 28, 2006, the Company and Dolphin entered
into a Cancellation and Warrant Exchange Agreement (the “Cancellation
Agreement”) under which Dolphin agreed to cancel its Senior Subordinated Secured
Convertible Promissory Note and cancel its outstanding warrant to purchase
380,952 shares of GSE common stock at an exercise price of $2.22 per
share.   In exchange for Dolphin’s agreement to enter into the
Cancellation Agreement and for the participation of Dolphin Offshore Partners,
LP in the Preferred Stock transaction, the Company repaid the Dolphin Note and
agreed to issue a new warrant to purchase 900,000 shares of GSE common stock at
an exercise price of $0.67 per share.





In
conjunction with the early payoff of the Dolphin Note and the cancellation of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000; recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature and
the related warrants and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin.





Other Income (Expense),
Net.  For the years ended December 31, 2007 and 2006, other
income (expense), net was ($566,000) and ($105,000),
respectively.  The major components of other income (expense), net
include the following items:





 ̈
            The
      Company accounts for its investment in ESA using the equity
      method.  In accordance with the equity method, the Company has
      eliminated 10% of the profit from its ESA contract as the training
      simulators are assets that will be recorded on the books of ESA, and the
      Company is thus required to eliminate its proportionate share of the
      profit included in the asset value.  The profit elimination
      totaled $444,000 and $251,000 for the years ended December 31, 2007 and
      2006, respectively.  In addition, the Company recognized a
      $54,000 equity loss on the Company’s investment in ESA in the year ended
      December 31, 2007.





 ̈
            At
      December 31, 2007, the Company had contracts for the sale of approximately
      36 million Japanese Yen and 125,000 Pounds Sterling at fixed rates. The
      contracts expire on various dates through January 2008.  The
      Company had not designated the contracts as hedges and has recorded the
      change in the estimated fair value of
      the contracts of ($11,000) in other income (expense).  The
      estimated fair value of the contracts was $1,000 at December 31, 2007 and
      was recorded on the balance sheet under other current
      assets.


36




 ̈
            At
      December 31, 2006, the Company had contracts for sale of approximately 142
      million Japanese Yen at fixed rates. The contracts expired on various
      dates through August 2007.  The Company had not designated the
      contracts as hedges and recorded the estimated change in the fair value of
      the contracts of ($24,000) in other income (expense).  The
      estimated fair value of the contracts was $12,000 at December 31, 2006 and
      was recorded on the balance sheet under other current
    assets.





 ̈
            Foreign
      currency transaction losses totaled $60,000 for the year ended December
      31, 2007 versus foreign currency transaction gains of $128,000 for the
      year ended December 31, 2006,
respectively.





 ̈
            Other
      miscellaneous income items totaled $3,000 and $42,000 in the years ended
      December 31, 2007 and 2006,
respectively.





Provision for Income
Taxes.




In July
2006, the Financial Accounting Standards Board, or FASB, issued Interpretation,
or FIN, No. 48, Accounting for Uncertainty in Income
Taxes — An Interpretation of FASB Statement No. 109, “Accounting for Income
Taxes”. FIN No. 48 clarifies the accounting for
uncertainty in income taxes recognized in the Company’s financial statements. It
also prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of tax positions taken or
expected to be taken in a tax return. This interpretation also provides guidance
on derecognition, classification, interest and penalties, accounting in interim
periods and expanded disclosure with respect to uncertainty in income taxes. The
Company adopted the guidance of FIN No. 48 effective January 1, 2007.
The adoption of this accounting pronouncement did not have a material effect on
the Company’s financial position, results of operations or cash flows.
Furthermore, the Company is not aware of any tax positions for which it is
reasonably possible that the total amounts of unrecognized tax benefits would
significantly decrease or increase within the next twelve months.




The
Company files in the United States federal jurisdiction and in several state and
foreign jurisdictions. Because of the net operating loss carryforwards, the
Company is subject to U.S. federal and state income tax examinations from years
1997 and forward and is subject to foreign tax examinations by tax authorities
for years 2002 and forward.  Open tax years related to state and
foreign jurisdictions remain subject to examination but are not considered
material to our financial position, results of operations or cash
flows.




As of
December 31, 2007, there have been no material changes to the liability for
uncertain tax positions.




The
Company’s tax provision in 2007 was $43,000 and consisted of $147,000 foreign
income tax withholding on several non-U.S. contracts and $7,000 state income
taxes which were partially offset by a federal income tax benefit of $111,000
(the benefit mainly reflects the reversal of the tax benefit from the exercise
of employee stock options recognized in 2006 due to an increase in the Company's
estimate of the annual amount of net operating loss carryforwards
available).
  The
Company’s tax provision in 2006 was $149,000 and consisted of foreign income
taxes of $17,000 and state income taxes of $29,000 and federal income taxes of
$103,000.





The
Company has a full valuation allowance on its deferred tax assets at December
31, 2007.


37







Comparison of the Years Ended
December 31, 2006 to December 31, 2005.





Contract Revenue.Revenue for
the year ended December 31, 2006 was $27.5 million versus $22.0 million for the
year ended December 31, 2005, a 25.0% increase.  The increase reflects
an increase in orders and higher volume in 2006.  Total orders logged
in 2006 totaled $33.5 million (including a $15.1 million contract received from
ESA) as compared to $15.3 million in 2005.  For the twelve months
ended December 31, 2006, the Company recognized $5.7 million of contract revenue
on the ESA project, which accounted for 20.7% of the Company’s consolidated
revenue.  The Company settled an outstanding claim with a customer for
work performed through December 31, 2005 of approximately $265,000, of which
$120,000 was recognized as revenue in 2005 and the balance was recognized as
revenue in 2006.  License revenue totaled $1.2 million for the twelve
months ended December 31, 2006 versus only $472,000 in 2005.   At
December 31, 2006, the Company’s backlog was $18.5 million.





Gross Profit.Gross profit
increased from $3.3 million (15.3% of revenue) for the year ended December 31,
2005 to $7.9 million (28.7% of revenue) for the year ended December 31,
2006.  2006 gross margin was favorably impacted by the ESA contract,
the increase in license revenue and the settlement of the outstanding claim
discussed above.  In 2005, the Company had made certain adjustments to
the estimated costs to complete several of its long-term contracts which
resulted in a net reduction of the contract-to-date gross profit recognized on
the contracts of approximately $895,000 or 4% of revenue.





Selling, General and Administrative
Expenses.  Selling, general and administrative (“SG&A”)
expenses totaled $4.9 million in the year ended December 31, 2006, a 29.2%
decrease from the $7.0 million for 2005. The reduction reflects the following
spending variances:





 ̈
            Business
      development and marketing costs decreased from $3.0 million for the year
      ended December 31, 2005 to $2.1 million in 2006.  In order to
      reduce operating expenses, the Company terminated several of its business
      development personnel in mid-2005 and reassigned others to operating
      positions.





 ̈
            The
      Company’s general and administrative expenses totaled $2.3 million in the
      year ended December 31, 2006, which was 16.2% lower than the $2.9 million
      incurred in 2005.    The reduction reflects lower
      facility costs in 2006 due to the restructuring of the Company’s leased
      facilities in late 2005 (the assignment of the Columbia, Maryland facility
      and the move of the Company’s headquarters to the Baltimore, Maryland
      facility) plus the reassignment of one executive from corporate to an
      operating position.





 ̈
            Gross
      spending on software product development (“development”) totaled $871,000
      for the twelve months ended December 31, 2006 versus $758,000 in the same
      period of 2005.   For the year ended December 31, 2006, the
      Company expensed $538,000 and capitalized $333,000 of its development
      spending while in the year ended December 31, 2005, the Company expensed
      $275,000 and capitalized $483,000 of its development
      spending.  The Company’s capitalized development expenditures in
      2006 were related to the development of new features for the Xflow
      modeling tool for
      modeling power plant buildings and the development of new features for the
      THEATRe thermo-hydraulic and REMARK core
  models.


38




 ̈
            In
      2005, the Company implemented staff reductions; 2005 SG&A expense
      reflected $301,000 of accrued
severance.





 ̈
            The
      Company increased its reserve for bad debts by $496,000 for the twelve
      months ended December 31, 2005.





Administrative Charges from GP
Strategies.The Company extended its Management Services
Agreement with GP Strategies Corporation through December 31,
2006.  Under the agreement, GP Strategies provided corporate support
services to GSE, including accounting, finance, human resources, legal, network
support and tax.  In addition, GSE used the financial system of
General Physics, a subsidiary of GP Strategies. The Company was charged $685,000
in both the twelve months ended December 31, 2006 and 2005.  The
Company terminated the agreement on December 31, 2006.





Depreciation and
Amortization.For the years ended December 31, 2006 and 2005,
depreciation expense totaled $186,000 and $431,000, respectively.  Due
to the relocation of the Company’s Maryland operations from Columbia, Maryland
to Baltimore, Maryland, the Company accelerated the depreciation of certain
leasehold improvements in 2005 which resulted in lower depreciation expense in
2006.





Operating Income (Loss).The Company had
an operating income of $2.1 million (7.6% of revenue) for the year ended
December 31, 2006, as compared with an operating loss of $4.7 million (21.5% of
revenue) for the prior year.  The variances were due to the factors
outlined above.





Interest Expense, Net.Net interest
expense increased from $416,000 in the year ended December 31, 2005 to $764,000
for the year ended December 31, 2006.





The
Company incurred interest expense of $264,000 and $57,000 on borrowings against
its credit facilities in the twelve months ended December 31, 2006 and 2005,
respectively.





Amortization
of deferred financing costs related to the Company’s lines of credit totaled
$200,000 in 2006 versus only $37,000 in 2005.  The increase reflects
the replacement of the Wachovia Bank credit facility with one from Laurus Master
Fund, Ltd in early 2006.





Amortization
of the cost of the warrants issued to Laurus in conjunction with the new credit
facility totaled $251,000 in 2006.





The Company incurred interest expense
of $26,000 and $96,000 on the Dolphin Note in 2006 and 2005,
respectively.   Also included in interest expense was original
issue discount accretion related to the Dolphin Note and GSE Warrant of $58,000
and $203,000, in the twelve months ended December 31, 2006 and 2005,
respectively.





Interest accrued on the preferred
dividends payable to ManTech was $20,000 for the year ended December 31, 2006
and $21,000 for the same period of 2005.  Other interest expense
totaled $11,000 in both years.


39


The Company earned interest income of
$66,000 in the twelve months ended December 31, 2006 versus only $9,000 in the
twelve months ended December 31, 2005.  The increase reflects the
increase in cash deposited into certificates of deposit as collateral for
performance bonds.  This cash is classified on the balance sheet as
restricted cash.





Loss on Extinguishment of
Debt.  On February 28, 2006, the Company and Dolphin entered
into a Cancellation and Warrant Exchange Agreement (the “Cancellation
Agreement”) under which Dolphin agreed to cancel its Senior Subordinated Secured
Convertible Promissory Note and cancel its outstanding warrant to purchase
380,952 shares of GSE common stock at an exercise price of $2.22 per
share.   In exchange for Dolphin’s agreement to enter into the
Cancellation Agreement and for the participation of Dolphin Offshore Partners,
LP in the Preferred Stock transaction, the Company repaid the Dolphin Note and
agreed to issue a new warrant to purchase 900,000 shares of GSE common stock at
an exercise price of $0.67 per share.





In
conjunction with the early payoff of the Dolphin Note and the cancellation of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000, recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature and
the related warrants, and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin.





Other Income (Expense),
Net.Other Income (Expense), net was ($105,000) in 2006
versus $497,000 in 2005.





At December 31, 2006, the Company had
contracts for sale of approximately 142 million Japanese Yen at fixed rates. The
contracts expired on various dates through August 2007.  The Company
did not designate the contracts as hedges and recorded the estimated change in
the fair value of the contracts of ($24,000) in other income
(expense).  The estimated fair value of the contracts was $12,000 at
December 31, 2006 and was recorded on the balance sheet under other current
assets.





At December 31, 2005, the Company had
contracts for the sale of approximately 247 million Japanese Yen at fixed
rates.  The Company had not designated the contracts as hedges and
recorded the change in the estimated fair value of the contracts during 2005 of
($170,000) in other income (expense), net.  The estimated fair value
of the contracts was $31,000 as of December 31, 2005.  $20,000 of the
fair value was recorded on the balance sheet under other current assets, and the
balance was classified under other assets.





The
Company accounts for its investment in ESA using the equity method.In
accordance with the equity method, the Company has eliminated 10% of the profit
from this contract as the training simulators are assets that will be recorded
on the books of ESA, and the Company is thus required to eliminate its
proportionate share of the profit included in the asset value.  The
profit elimination totaled $251,000 for the year ended December 31, 2006,
respectively, and has been recorded as an other expense in the income statement
and as an other liability on the balance sheet.  Once ESA begins to
amortize the training simulators on their books, GSE will begin to amortize the
other liability to other income.





The
Company incurred foreign currency transaction gains of $128,000 in the twelve
months ended December 31, 2006 versus currency transaction losses of $35,000 in
2005.





40


In conjunction with the
Dolphin Note and GSE Warrants, the fair value of the GSE Warrant was $375,000
and the fair value of the Conversion Option of the Dolphin Note was
$959,000.  The GSE Warrant and Conversion O ption liabilities were
marked to market through earnings on a quarterly basis in accordance with EITF
No. 00-19, Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in a
Company’s Common Stock.   In 2005, the Company recognized
a gain of $636,000 from the change in fair market value of these liabilities as
of December 31, 2005.





Other miscellaneous income items
totaled $42,000 and $66,000 in the years ended December 31, 2006 and 2005, respectively.





Provision for Income
Taxes.The Company’s
tax provision in 2006 was $149,000 and consisted of foreign income taxes of
$17,000 and state income taxes of $29,000 and federal income taxes of
$103,000.  The Company has a full valuation allowance on its deferred
tax assets.





In 2005,
the Company’s tax provision was $149,000 and consisted of foreign income taxes
of $103,000, deferred income taxes of $50,000 and state income taxes of
($4,000).








Liquidity and Capital
Resources.





As of
December 31, 2007, GSE had cash and cash equivalents of $8.2 million versus $1.1
million at December 31, 2006.





Cash From Operating
Activities.Net cash provided by operating activities was $1.9
million for the year ended December 31, 2007 and increased $2.5 million as
compared to 2006, reflecting an increase in net income before non-cash items
(such as depreciation, amortization, stock-based compensation expense, and
elimination of profit of the ESA contract).  The most significant
change in the Company’s assets and liabilities in 2007 was a $1.6 million
reduction in the Company’s accounts payable, accrued compensation and accrued
expenses.   After the completion of the Company’s June 2007
common stock transaction, the Company paid $405,000 to ManTech for the preferred
stock dividends that had been payable since 2003 and the related accrued
interest.  The balance of the reduction was mainly due to the paydown
of the Company’s trade payable balance.





Net cash
used in operating activities was $594,000 for the year ended December 31,
2006.  The loss on early extinguishment of debt of $1.4 million was a
non-cash expense that had no impact on the Company’s operating cash
flow.  Significant changes in the Company’s assets and liabilities in
2006 included:





 ̈
            A
      $3.8 million increase in contracts receivable.  An invoice for
      $1.7 million was issued to ESA in August 2006 and was still outstanding at
      December 31, 2006.  The Company received the $1.7 million in May
      2007.  In addition, the Company had an unbilled receivable of
      $1.9 million for the ESA contract at December 31,
  2006.


 ̈
            A
      $690,000 increase in billings in excess of revenues earned.  The
      increase is related to the timing of milestone billings on several
      projects.


 ̈
            A
      $536,000 decrease in the amount due to GP Strategies
      Corporation.  The reduction reflects the utilization of a
      portion of the funds received through the Company’s convertible preferred
      stock transaction to pay down the balance due to GP Strategies. The
      Company paid off the balance due to GP Strategies prior to the termination
      of the Management Services Agreement on December 31,
  2006.


41


For the
year ended December 31, 2005, net cash used in operating activities was $1.9
million. Significant changes in the Company’s assets and liabilities in 2005
included:





 ̈
            A
      $1.8 decrease in contracts receivable.  The decrease reflected
      the combination of (a) a decrease in outstanding trade receivables of $1.0
      million due to the lower project activity in 2005, (b) a decrease in
      unbilled receivables of $560,000 due to the timing of contract invoicing
      milestones, and (c) an increase in the bad debt reserve of
      $220,000.


 ̈
            An
      $810 decrease in prepaid expenses and other assets.   The
      decrease mainly reflected the following items:  (a) the
      amortization of fees incurred in 2004 related to the issuance of project
      advance payment and performance bonds, (b) the reduction of an advance
      payment to a subcontractor in 2004 as the subcontractor performed the
      related work, and (c) the reduction in the fair value of the Company’s
      hedging contracts.





Cash Used in Investing
Activities.Net cash used in investing activities was $3.5
million for the year ended December 31, 2007.  The Company made
capital expenditures of $778,000, capitalized software development costs of
$673,000, and made an additional investment in ESA of $261,000.  The
Company deposited $1.2 million into a restricted, interest-bearing account at
the Union National Bank in the United Arab Emirates as a partial guarantee for
the $11.8 million credit facility that the bank extended to ESA.  The
Company also restricted $700,000 of cash as collateral for performance bonds
issued by the Company and backed by standby letters of credit.





For the
year ended December 31, 2006, net cash used in investing activities was $3.1
million consisting of $333,000 of capitalized software development costs,
$185,000 of capital expenditures, and the restriction of $2.3 million of cash as
collateral for five performance bonds issued by the Company and backed by
standby letters of credit.  The largest is a $2.1 million performance
bond issued to ESA which expires on October 31, 2008.  In addition,
the Company invested $238,000 in ESA.





Net cash
used in investing activities was $692,000 for the year ended December 31,
2005.  The Company made capital expenditures of $182,000 and
capitalized software development costs of $483,000.





Cash Provided by Financing
Activities.  In
the year ended December 31, 2007, the Company generated $8.7 million from
financing activities.  The Company generated net proceeds of $9.2
million from the issuance of 1,666,667 shares of common stock and warrants which
was used to pay down the Laurus Master Fund, Ltd. line of credit.  The
Company generated $2.1 million from the exercise of warrants and employee stock
options.  The Company reversed a tax benefit of $115,000 related to
employee stock option exercises that had been recognized in 2006.  The
Company paid dividends of $49,000 to the Series A Cumulative Convertible
Preferred stockholders and paid the $316,000 preferred stock dividend that was
due to ManTech since 2003.





The
Company generated $3.4 million from financing activities in the twelve months
ended December 31, 2006.  The Company generated net proceeds of $3.9
million from the issuance of 42,500 shares of Series A Cumulative Convertible
Preferred Stock and Warrants which were used to pay off the $2.0 million Dolphin
Note and the outstanding borrowings under the Company’s bank line of credit
($1.2 million).





42


The
Company entered into a new credit facility with Laurus Master Fund on March 7,
2006 and had outstanding borrowings under the credit facility on December 31,
2006 of $2.2 million. In conjunction with the establishment of the Laurus line
of credit, the Company incurred cash financing costs of $448,000.  On
May 18,2006, Laurus Master Fund agreed to temporarily increase the
Company’s borrowing capability by $2.0 million over and above the funds that
were available to the Company based upon its normal borrowing base
calculation.  The over advance was used to collateralize a $2.1
million performance bond that the Company issued to the Emirates Simulation
Academy, LLC in the form of a standby letter of credit.  One half of
the increased borrowing capability expired on July 18, 2006, and the balance
expired on April 13, 2007.  The Company’s borrowings over and above
the normal borrowing base calculation bore additional interest of 1.5% per month
over and above the normal interest rate on the line of
credit.





The
Company received $409,000 through the issuance of common stock due to the
exercise of employee stock options, and $730,000 through the issuance of common
stock due to the exercise of warrants.  The Company recognized a tax
benefit of $124,000 related to the employee stock option exercises.





In 2006,
the Company paid dividends of $279,000 to the preferred
stockholders.





For the
year ended December 31, 2005, the Company generated $3.0 million in cash from
financing activities.  The Company borrowed $1,182,000 from its bank
line of credit, generated $100,000 from the exercise of employee stock options,
and issued to Dolphin Direct Equity Partners, LP a Senior Subordinated Secured
Convertible Note in the aggregate principle amount of $2,000,000. The Company
incurred $197,000 of deferred financing costs related to the Dolphin Note and
paid down a note payable of $9,000.








Credit Facilities





At December 31, 2007, the Company has a
$5.0 million line of credit with Laurus Master Fund, Ltd.  The line is
collateralized by substantially all of the Company’s assets and provides for
borrowings up to 90% of eligible accounts receivable and 40% of eligible
unbilled receivables (up to a maximum of $1.0 million).  The interest
rate on this line of credit is based on the prime rate plus 200-basis points
(9.25% as of December 31, 2007), with interest only payments due
monthly.  The credit facility does not require the Company to comply
with any financial ratios.  Because the Laurus line of credit
agreement includes both a subjective acceleration clause and a requirement to
maintain a lock-box arrangement whereby remittances for GSE’s customers reduce
the outstanding debt, the borrowings under the line of credit have been
classified as short-term obligations on the balance sheet.  At
December 31, 2007, the Company’s available borrowing base was $2.3 million, none
of which had been utilized.   The credit facility expired on
March 6, 2008.





The
Company is finalizing two new loan and security agreements with Bank of America
that will provide revolving lines of credit up to an aggregate $5.0 million. The
Company and its subsidiary, GSE Power Systems, Inc., will be jointly and
severally liable as co-borrowers.  The credit facilities will enable
the Company to borrow funds to support working capital needs and standby letters
of credit.  The first line of credit in the principal amount of $3.5
million will enable the Company to borrow funds up to 90% of eligible foreign
accounts receivable, and 75% of eligible unbilled foreign receivables. The line
of credit will be 90% guaranteed by the Export-Import Bank of the United
States.  The interest rate on this line of credit will be based on the
one-month LIBOR rate plus 150 basis points, with interest only payments due
monthly.  The second line of credit in the principal amount of $1.5
million will enable the Company to borrow funds up to 80% of domestic accounts
receivable and 30% of domestic unbilled receivables.  The interest
rate on this line of credit will be based on the one-month LIBOR rate plus 225
basis points, with interest only payments due monthly.   The
credit facilities will require the Company to comply with certain financial
ratios and preclude the Company from paying dividends and making acquisitions
beyond certain limits without the bank’s consent.  The Company expects
to close on the new loan and security agreements by March 31,
2008.


43


Common Stock and Warrant
Transaction





On June
22, 2007, the Company raised $9.2 million, net of associated fees of $768,000,
through the sale of 1,666,667 shares (the “Shares”) of its common stock, $.01
par value per share, by means of a private placement to selected institutional
investors.  Each investor received a five-year warrant to purchase GSE
common stock (the “Warrant Shares”) equal to 10% of the shares of common stock
that they had purchased at an exercise price of $6.00 per share (the
“Warrants”).  In aggregate, the Company issued Warrants to purchase a
total of 166,667 shares of GSE common stock.





The
Company filed its registration statement on Form S-3 (the “Registration
Statement”) with the Securities and Exchange Commission (the “Commission”) on
July 16, 2007 covering the offer and sale, from time to time, of the Shares, the
Warrant Shares and shares of common stock issuable upon exercise of warrants
that may be issued as liquidated damages under the terms of a certain
registration rights agreement entered into between the Company and the investors
(the “Registration Rights Agreement”) in connection with the private
placement.  The Registration Statement became effective on August 8,
2007 and, pursuant to the provisions of the Registration Rights Agreement, the
Company is obligated to use commercially reasonable efforts to, after the date
on which the Registration Statement becomes effective, cause the Registration
Statement to remain continuously effective as to all Shares and Warrant Shares,
other than for an aggregate of more than 30 consecutive trading days or for more
than an aggregate of 60 trading days in any 12-month period. In the event of a
default of the foregoing obligation, the Company will be required to issue to
the investors, as liquidated damages, on the date the foregoing default occurs
and each monthly anniversary thereafter, a number of warrants (on the same terms
as the Warrants) equal to 2% of the number of Shares then held by such investor,
not to exceed 10% of the total number of Shares then held by such investor, and
thereafter cash, in an amount equal to 2% of the aggregate purchase price paid
by the investors, not to exceed 30% of the aggregate purchase price paid by the
investors.





At the
date of issuance, the fair value of the Warrants was $510,000 and the fair value
of the Shares was $9.5 million.  The fair value of the Warrants and
the Shares was determined by the use of the relative fair value method, in which
the $10.0 million gross proceeds was allocated based upon the fair values of the
Warrants, as determined by using the Black-Scholes Model, and the Shares, as
determined by the closing price of the common stock on the American Stock
Exchange on the date the transaction was closed.





The
Company paid the placement agent a fee in the amount of 6% of the gross proceeds
received by the Company from the offering ($600,000).  In addition to
the placement agent fee, the Company paid $168,000 of other transaction fees
related to the offering.





The
proceeds were used to pay down the Company’s line of credit and for other
working capital purposes.





Senior Convertible Secured Subordinated Note
Payable





On May 26, 2005, GSE issued and sold
to Dolphin Direct Equity Partners, LP (“Dolphin”) a Senior Subordinated Secured
Convertible Note in the aggregate principal amount of $2,000,000 which was to
mature on March 31, 2009 (the “Dolphin Note”), and a seven-year warrant to
purchase 380,952 shares of GSE common stock at an exercise price of $2.22 per
share (the “GSE Warrant”).  The Dolphin Note was convertible into
1,038,961 shares of GSE common stock at an exercise price of $1.925 per share
and accrued interest at 8% payable quarterly. On
February 28, 2006, the Company and Dolphin entered into a Cancellation and
Warrant Exchange Agreement (the “Cancellation Agreement”) under which Dolphin
agreed to cancel its Senior Subordinated Secured Convertible Promissory Note and
cancel its outstanding warrant to purchase 380,952 shares of GSE common stock at
an exercise price of
$2.22 per share.  In exchange for Dolphin’s agreement to enter into
the Cancellation Agreement, the Company repaid the Dolphin Note and agreed to
issue a new warrant to purchase 900,000 shares of GSE common stock at an
exercise price of $.67 per share (the “Dolphin Warrant”).  At the date
of issuance, the fair value of the Dolphin Warrant was $868,000, as established
using the Black-Scholes Model, and was recorded in paid-in capital with the
offset recorded as loss on extinguishment of debt.  In accordance with
the terms of the warrant agreement, Dolphin exercised the Dolphin Warrant on
November 8, 2006 upon the Company’s certification that, among other things, the
underlying shares of GSE common stock were registered with the Securities and
Exchange Commission on October 31, 2006, that the current stock price was
greater than $1.25 per share, and that the average of the current stock prices
for each trading day of the prior 30 calendar day period was not less than $1.25
per share.  The Company received cash proceeds of
$603,000.


44





In
conjunction with the early payoff of the Dolphin Note and the cancellation of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000; recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature and
the related warrants and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin.  The total loss on extinguishment of
the Dolphin Note and the cancellation of the related warrants totaled $1.4
million.





Series A Cumulative Preferred
Stock





On February 28, 2006, the Company
raised $3.9 million, net of associated fees of $395,000, through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to “accredited investors”, as that term is used in
rules and regulations of the Securities and Exchange Commission.  The
Convertible Preferred Stock was convertible at any time into a total of
2,401,133 shares of GSE common stock at a conversion price of $1.77 per share.
The conversion price was equal to 110% of the closing price of the Company’s
Common Stock on February 28, 2006, the date the sale of the Convertible
Preferred Stock was completed.  Each investor received a five-year
warrant to purchase GSE common stock equal to 20% of the shares they would
receive from the conversion of the Convertible Preferred Stock, at an exercise
price of $1.77.  In aggregate, the Company issued warrants to purchase
a total of 480,226 shares of GSE common stock.  The Convertible
Preferred Stock holders were entitled to an 8% cumulative dividend, payable on a
semiannual basis every June 30 and December 30.  In 2006, the Company
paid dividends totaling $279,000 to the preferred stockholders; in the nine
months ended September 30, 2007 the Company paid dividends totaling
$49,000.  At the date of issuance, the fair value of the warrants was
$342,000 and the fair value of the preferred stock was $3.9 million. The fair
value of the warrants and the preferred stock was determined by the use of the
relative fair value method, in which the $4.25 million gross proceeds was
allocated based upon the fair values of the warrants, as determined by using the
Black-Scholes Model, and the preferred stock, as determined by an independent
appraisal.  At any time after March 1, 2007, the Company had the right
to convert the Preferred Stock into shares of GSE common stock when the average
of the current stock price during the twenty trading days immediately prior to
the date of such conversion exceeded 200% of the Series A Conversion
Price.  On March 7, 2007, the Company sent notice to the holders of
the remaining 20,000 outstanding shares of its Preferred Stock that the average
current stock price for the prior twenty trading days had exceeded 200% of the
Conversion Price, and that the Company was converting the outstanding Preferred
Stock into common stock.  The 20,000 shares of Preferred Stock
converted to 1,129,946 shares of GSE common stock.  Prior to March 7,
2007, the holders of 22,500 shares of Preferred Stock had already elected to
convert their Preferred Stock into a total of 1,271,187 shares of Common Stock;
8,580 shares of Preferred Stock were converted in 2006 and 13,920 shares of
preferred Stock in 2007.


45


The Company paid the placement agent
for the Convertible Preferred Stock and Warrants 6% of the gross proceeds
received by the Company from the offering ($255,000) plus five-year warrants to
purchase 150,000 shares of the Company’s common stock at an exercise price of
$1.77 per share. In addition to the placement agent fee, the Company paid
$140,000 of other transaction fees related to the offering.  At the
date of issuance, the fair value of the placement agent warrants was $128,000,
as established using the Black-Scholes Model, and was recorded in paid-in
capital, with the offset recognized as a reduction of the preferred stock
proceeds.







Contractual Cash
Commitments




The
following summarizes the Company’s contractual cash obligations as of December
31, 2007, and the effect
these obligations are expected to have on its liquidity and cash flow in future
periods:




Payments Due by
      Period(in
      thousands)Contractual Cash
      Obligations
              Total
              Less than 1
      year
              1-3
Years
              4-5
Years
              After 5
      YearsSubcontractor and Purchase
      Commitments
              $     3,433
              $    3,335
              $  
              98
              $    
               -
              $     
           -Net future minimum lease
      payments
              $     4,977
              $       730
              $     1,192
              $        820
              $  2,235Total
              $     8,410
              $    4,065
              $     1,290
              $        820
              $  2,235


In
October 2005, the Company signed an “Assignment of Lease and Amendment to Lease”
that assigned and transferred to another tenant (the “assignee”) the Company’s
rights, title and interest in its Columbia, Maryland facility
lease.  The assignee’s obligation to pay rent under the Lease began on
February 1, 2006.  The Company remains fully liable for the payment of
all rent and for the performance of all obligations under the lease through the
scheduled expiration of the lease, May 31, 2008, should the assignee default on
their obligations.  At December 31, 2007, the remaining rental
payments under the lease totaled $285,000.  The Company relocated its
Maryland operations from its Columbia facility to its Baltimore facility in
October 2005.





As of
December 31, 2007, the Company was contingently liable for six letters of credit
totaling $2.9 million.  The letters of credit represent performance
bonds on six contracts and have been cash collateralized.





The
Company has deposited $1.2 million into a restricted, interest-bearing account
at the Union National Bank (“UNB”) in the United Arab Emirates as a partial
guarantee for the $11.8 million credit facility that UNB has extended to
ESA.  The guarantee will be in place until the expiration of the ESA
credit facility on December 31, 2014 or earlier if ESA pays down and
terminates the credit facility.


46





2008 Liquidity
Outlook





At December 31, 2007, the Company had
cash and cash equivalents of $8.2 million and another $2.3 million available
under its line of credit.   In addition, the Company’s milestone
billings backlog at December 31, 2007 totaled $19.7 million.  The
Company is finalizing two new loan and security agreements with Bank of America
that will provide for an aggregate total of $5.0 million, replacing the
Company’s $5.0 million line of credit with Laurus Master Fund,
Ltd.   The Company anticipates that its normal operations and the
utilization of its new credit facility will generate all of the funds necessary
to fund its consolidated operations during the next twelve
months.  The Company believes that it will have sufficient liquidity
and working capital without additional financing.  However,
notwithstanding the foregoing, the Company may be required to look for
additional capital to fund its operations if the Company is unable to operate
profitably and generate sufficient cash from operations.  There can be
no assurance that the Company would be successful in raising such additional
funds.





Foreign Exchange.





A portion
of the Company's international sales revenue has been and may be received in a
currency other than the currency in which the expenses relating to such revenue
are paid.  When necessary, the Company enters into forward exchange
contracts, options and swap agreements as hedges against certain foreign
currency commitments to hedge its foreign currency risk.





Off-balance Sheet
Obligations.





The
Company has no off-balance sheet obligations as of December 31, 2007, except for
its operating lease commitments and outstanding letters of
credit.  See Contractual Cash Commitments
above.





Accounting Standard
Adopted.




In July
2006, the Financial Accounting Standards Board, or FASB, issued Interpretation,
or FIN, No. 48, Accounting for Uncertainty in Income
Taxes — An Interpretation of FASB Statement No. 109, “Accounting for Income
Taxes”. FIN No. 48
clarifies the accounting for uncertainty in income taxes recognized in our
financial statements. It also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of tax
positions taken or expected to be taken in a tax return. This interpretation
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods and expanded disclosure with respect to
uncertainty in income taxes. The Company adopted the guidance of FIN No. 48
effective January 1, 2007. The adoption of this accounting pronouncement
did not have a material effect on the Company’s financial position, results of
operations or cash flows. Furthermore, the Company is not aware of any tax
positions for which it is reasonably possible that the total amounts of
unrecognized tax benefits would significantly decrease or increase within the
next twelve months.




The
Company files in the United States federal jurisdiction and in several
state and foreign jurisdictions. Because of the net operating loss
carryforwards, the Company is subject to U.S. federal and state income tax
examinations from years 1997 and forward and is subject to foreign tax
examinations by tax authorities for years 2002 and forward. Open tax years
related to state and foreign jurisdictions remain subject to examination but are
not considered material to our financial position, results of operations or cash
flows.


47


The Company’s policy for recording
interest and penalties associated with uncertain tax positions is to record such
items as a component of income before taxes.  As of December 31, 2007,
the Company has no accrued interest or penalties.





As of December 31, 2007, there have
been no material changes to the liability for uncertain tax
positions.





New Accounting
Standards.




In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement No. 157, Fair
Value Measurements(“SFAS 157”).
SFAS 157 defines fair value, establishes a framework for measuring fair
value and expands disclosure requirements regarding fair value measurements.
SFAS 157 does not require any new fair value measurements. However, on
February 12, 2008 the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No.
157 (“FSP FAS 157-2”).  FSP FAS 157-2 delays the effective date
of SFAS 157 for all nonfinancial assets and nonfinancial liabilities until
fiscal years beginning after November 15, 2008 and interim periods within those
fiscal years.  The Company does not believe the adoption of this
standard will have a material effect on its financial position, results of
operations or cash flows.




In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial
Assets and Liabilities--- Including an Amendment of FASB Statement No. 115(“SFAS 159”), which permits entities to measure eligible items at fair
value.  For items where the fair value election is made, the Company
will be required to report unrealized gains or losses in
earnings.  Statement 159 is effective January 1, 2008.  The
Company is currently assessing the impact the adoption of this statement will
have on our consolidated financial statements.





In December, 2007, the FASB issued
SFAS No. 141(R), Business Combinations
(“SFAS 141(R)”), which applies prospectively to business combinations for
which the acquisition date is on or after the beginning of the first annual
reporting period beginning on or after December 15, 2008. An entity may not
apply it before that date. SFAS 141(R) establishes principles and
requirements for how the acquirer: i) recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed
and any noncontrolling interest in the acquiree; ii) recognizes and
measures the goodwill acquired in the business combination or a gain from a
bargain purchase; and iii) determines what information to disclose to
enable users of the financial statements to evaluate the nature and financial
effects of the business combination. The Company does not expect the adoption of
SFAS 141 (R) to have an effect on its results of operations and its
financial condition unless it enters into a business combination after
January 1, 2009.





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research
Bulletin No. 51 (“SFAS 160”). SFAS 160 establishes
accounting and reporting standards for ownership interests in subsidiaries held
by parties other than the parent, the amount of consolidated net income
attributable to the parent and to the noncontrolling interest, changes in a
parent’s ownership interest and the valuation of retained noncontrolling equity
investments when a subsidiary is deconsolidated. SFAS 160 also establishes
disclosure requirements that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling owners. The
Company is required to adopt the provisions of SFAS 160 effective January 1,
2009.  The Company is currently evaluating the potential impact, if
any, of the adoption of SFAS 160 on its consolidated financial
operations.







48


Other Matters.





Management believes inflation has not
had a material impact on the Company's operations.








ITEM 7A.  QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK.





The Company’s market risk is
principally confined to changes in foreign currency exchange rates. During the
year ended December 31, 2007, 16% of the Company’s revenue was from contracts
which required payments in a currency other than U.S. Dollars, principally
Swedish Krona (8%) and British Pounds Sterling (5%).  For the years
ended December 31, 2006 and 2005,  18% and 14% respectively, of
the Company’s revenue was from contracts which required payments in a currency
other than U.S. Dollars, principally Swedish Krona and Japanese
Yen.





In
addition, during the years ended December 31, 2007, 2006 and 2005, 11%, 15% and
13%, respectively, of the Company’s expenses were incurred in Swedish
Krona.  The Company’s exposure to foreign exchange rate fluctuations
arises in part from inter-company accounts in which costs incurred in one entity
are charged to other entities in different foreign jurisdictions.  The
Company is also exposed to foreign exchange rate fluctuations as the financial
results of all foreign subsidiaries are translated into U.S. dollars in
consolidation.  As exchange rates vary, those results when translated
may vary from expectations and adversely impact overall expected
profitability.





The
Company utilizes forward foreign currency financial instruments to manage market
risks associated with the fluctuations in foreign currency exchange rates. It is
the Company's policy to use derivative financial instruments to protect against
market risk arising in the normal course of business. The criteria the Company
uses for designating an instrument as a hedge include the instrument's
effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions.   The Company monitors
its foreign currency exposures to maximize the overall effectiveness of its
foreign currency hedge positions. Principal currencies hedged are the pound
sterling and the Japanese yen. The Company's objectives for holding derivatives
are to minimize the risks using the most effective methods to reduce the impact
of these exposures. The Company minimizes credit exposure by limiting
counterparties to nationally recognized financial institutions.





At December 31, 2007, the Company had
contracts for the sale of approximately 36 million Japanese Yen and 125,000
Pounds Sterling at fixed rates. The contracts expire on various dates through
January 2008.  The Company had not designated the contracts as hedges
and has recorded the change in the estimated fair value of the contracts of
($11,000) in other income (expense).  The estimated fair value of the
contracts was $1,000 at December 31, 2007.  The Company recognized
unrealized losses of approximately $23,000 and $170,000 in 2006 and 2005,
respectively, on its forward currency contracts.





The Company is also subject to market
risk related to the interest rate on its existing line of credit.  As
of December 31, 2007, such interest rate is based on the Prime Rate plus 200
basis-points.  A 100 basis-point change in such rate during the year
ended December 31, 2007 would have increased or decreased the Company’s annual
interest expense by approximately $11,000.











49


ITEM
8.                   FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA.





INDEX TO FINANCIAL
STATEMENTS





PageGSE Systems, Inc. and
      SubsidiariesReport
      of Independent Registered Public Accounting Firm-Internal Control over
      Financial Reporting
            F-1Report
      of Independent Registered Public Accounting Firm-Consolidated Financial
      Statements
            F-2Consolidated
      Balance Sheets as of December 31, 2007 and 2006
            F-3Consolidated
      Statements of Operations for the years ended
              December 31, 2007, 2006, and
      2005
            F-4Consolidated
      Statements of Comprehensive Income (Loss) for the years ended
              December 31, 2007, 2006, and
      2005
            F-5Consolidated
      Statements of Changes in Stockholders’ Equity for the years
      ended
              December 31, 2007, 2006, and
      2005
            F-6Consolidated
      Statements of Cash Flows for the years ended
              December 31, 2007, 2006, and
      2005
            F-7Notes
      to Consolidated Financial Statements
            F-8


50


Report of
Independent Registered Public Accounting Firm—Internal Control over Financial
Reporting





The Board
of Directors and Stockholders


GSE
Systems, Inc.:





We have
audited GSE Systems, Inc. and subsidiaries’ (the “Company”) internal control
over financial reporting as of December 31, 2007, based on criteria established
in Internal Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The Company's management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting, included in the accompanying Management’s Report on Internal Control
over Financial Reporting. Our responsibility is to express an opinion on the
Company’s internal control over financial reporting based on our
audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk. Our audit also included performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.





A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.





In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2007, based on criteria
established in Internal Control - Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO).





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of the Company
as of December 31, 2007 and 2006, and the related consolidated statements of
operations, comprehensive income (loss), changes in stockholders’ equity and
cash flows for each of the years in the three-year period ended December 31,
2007, and our report dated March 17, 2008 expressed an unqualified opinion on
those consolidated financial statements.











/s/
KPMG LLP





Baltimore,
Maryland


March 17,
2008


F-1


Report of
Independent Registered Public Accounting Firm











The Board
of Directors and Stockholders


GSE
Systems, Inc.:








We have
audited the accompanying consolidated balance sheets of GSE Systems, Inc. and
subsidiaries as of December 31, 2007 and 2006, and the related consolidated
statements of operations, comprehensive income (loss), changes in stockholders’
equity and cash flows for each of the years in the three-year period ended
December 31, 2007.  These consolidated financial statements are the
responsibility of the Company’s management.  Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements.  An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation.  We
believe that our audits provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of GSE Systems, Inc. and
subsidiaries as of December 31, 2007 and 2006, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2007 in conformity with U.S. generally accepted accounting
principles.





As
discussed in Note 2, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes – An Interpretation of FASB Statement No. 109, on January 1, 2007
and as discussed in Note 2, the Company adopted Statement of Financial
Accounting Standards No. 123 (Revised 2004), Share-Based Payment, on
January 1, 2006.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company’s internal control over financial
reporting as of December 31, 2007, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), and our report dated March 17,
2008 expressed an unqualified opinion on the effectiveness of the Company’s
internal control over financial reporting.














/s/ KPMG
LLP





Baltimore,
Maryland


March 17,
2008





F-2
  GSE SYSTEMS, INC. AND
      SUBSIDIARIESCONSOLIDATED BALANCE
      SHEETS(in thousands, except share
      data)December
      31,2007
              
              2006ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              
              
              
              
              
              $       8,172
              
              $       1,073Restricted
      cash
              
              
              
              
              
              
              
              2,228
              
              63Contract
      receivables
              
              
              
              
              
              
              10,721
              
              10,669Prepaid
      expenses and other current assets
              
              
              
              
              
              894
              
              494Total
      current assets
              
              
              
              
              
              
              22,015
              
              12,299Equipment
      and leasehold improvements, net
              
              
              
              
              
              880
              
              354Software
      development costs, net
              
              
              
              
              
              
              1,170
              
              820Goodwill
              
              
              
              
              
              
              
              
              1,739
              
              1,739Long-term
      restricted cash
              
              
              
              
              
              
              1,925
              
              2,291Other
      assets
              
              
              
              
              
              
              
              635
              
              945Total
      assets
              
              
              
              
              
              
              
              $     28,364
              
              $     18,448LIABILITIES AND STOCKHOLDERS'
      EQUITYCurrent
      liabilities:Current
      portion of long-term debt
              
              
              
              
              
              $            -
              
              $       2,155Accounts
      payable
              
              
              
              
              
              
              
              1,533
              
              2,461Accrued
      expenses
              
              
              
              
              
              
              
              1,061
              
              2,072Accrued
      compensation and payroll taxes
              
              
              
              
              
              1,613
              
              1,535Billings
      in excess of revenue earned
              
              
              
              
              
              2,270
              
              1,867Accrued
      warranty
              
              
              
              
              
              
              
              724
              
              746Other
      current liabilities
              
              
              
              
              
              
              103
              
              -Total
      current liabilities
              
              
              
              
              
              
              7,304
              
              10,836Other
      liabilities
              
              
              
              
              
              
              
              695
              
              251Total
      liabilities
              
              
              
              
              
              
              
              7,999
              
              11,087Commitments
      and contingenciesStockholders'
      equity:Preferred
      stock $.01 par value, 2,000,000 shares authorized,  shares
      issued andoutstanding
      none in 2007 and 33,920 in 2006
              
              
              
              
              -
              
              -Common
      stock $.01 par value, 30,000,000 shares authorized, shares issued
      andoutstanding
      15,508,014 in 2007 and 11,013,822 in 2006
              
              
              
              
              155
              
              110Additional
      paid-in capital
              
              
              
              
              
              
              49,225
              
              37,504Accumulated
      deficit
              
              
              
              
              
              
              (28,128)
              
              (29,297)Accumulated
      other comprehensive loss
              
              
              
              
              
              (887)
              
              (956)Total
      stockholders' equity
              
              
              
              
              
              
              20,365
              
              7,361Total
      liabilities and stockholders' equity
              
              
              
              
              
              $     28,364
              
              $     18,448The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-3


GSE SYSTEMS, INC. AND
      SUBSIDIARIESCONSOLIDATED STATEMENTS OF
      OPERATIONS(in thousands, except per
      share data)Years ended December
      31,2007
            
            
            2006
            
            
            2005Contract
      revenue
            
            $
            31,900
            
            
            $
            27,502
            
            
            $
            21,950Cost
      of revenue
            
            
            22,217
            
            
            
            19,602
            
            
            
            18,603Gross
      profit
            
            
            9,683
            
            
            
            7,900
            
            
            
            3,347Operating
      expensesSelling,
      general and administrative
            
            
            7,214
            
            
            
            4,929
            
            
            
            6,958Administrative
      charges from GP Strategies
            
            
            -
            
            
            
            685
            
            
            
            685Depreciation
            
            
            258
            
            
            
            186
            
            
            
            431Total
      operating expenses
            
            
            7,472
            
            
            
            5,800
            
            
            
            8,074Operating
      income (loss)
            
            
            2,211
            
            
            
            2,100
            
            
            
            (4,727
            )Interest
      expense, net
            
            
            (433
            )
            
            
            (764
            )
            
            
            (416
            )Loss
      on extinguishment of debt
            
            
            -
            
            
            
            (1,428
            )
            
            
            -Other
      income (expense), net
            
            
            (566
            )
            
            
            (105
            )
            
            
            497Income
      (loss) before income taxes
            
            
            1,212
            
            
            
            (197
            )
            
            
            (4,646
            )Provision
      for income taxes
            
            
            43
            
            
            
            149
            
            
            
            149Net
      income (loss)
            
            
            1,169
            
            
            
            (346
            )
            
            
            (4,795
            )Preferred
      stock dividends
            
            
            (49
            )
            
            
            (279
            )
            
            
            -Net
      income (loss) attributed to common shareholders
            
            $
            1,120
            
            
            $
            (625
            )
            
            $
            (4,795
            )Basic
      income (loss) per common share
            
            $
            0.09
            
            
            $
            (0.07
            )
            
            $
            (0.53
            )Diluted
      income (loss) per common share
            
            $
            0.08
            
            
            $
            (0.07
            )
            
            $
            (0.53
            )The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-4


GSE SYSTEMS, INC. AND
      SUBSIDIARIESCONSOLIDATED STATEMENTS OF
      COMPREHENSIVE INCOME (LOSS)(in
      thousands)Years
      ended December 31,2007
              
              2006
              
              2005Net
      income (loss)
              
              
              
              $           1,169
              
              $         (346)
              
              $     (4,795)Foreign
      currency translation adjustment
              
              69
              
              201
              
              (354)Comprehensive
      income (loss)
              
              
              $        1,238
              
              $         (145)
              
              $     (5,149)The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-5


GSE SYSTEMS, INC, AND
      SUBSIDIARIESCONSOLIDATED STATEMENTS OF
      CHANGES IN STOCKHOLDERS' EQUITY(in
      thousands)AccumulatedPreferred
            
            
            Common
            
            
            Additional
            
            
            
            
            
            OtherStock
            
            
            Stock
            
            
            Paid-in
            
            
            Accumulated
            
            
            ComprehensiveShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            Loss
            
            
            TotalBalance, January 1,
      2005
            
            
            -
            
            
            
            -
            
            
            
            8,950
            
            
            
            89
            
            
            
            30,815
            
            
            
            (24,156
            )
            
            
            (803
            )
            
            
            5,945Common
      stock issued foroptions
      exercised
            
            
            -
            
            
            
            -
            
            
            
            50
            
            
            
            1
            
            
            
            100
            
            
            
            -
            
            
            
            -
            
            
            
            101Foreign
      currency translationadjustment
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (354
            )
            
            
            (354
            )Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (4,795
            )
            
            
            -
            
            
            
            (4,795
            )Balance, December 31,
      2005
            
            
            -
            
            
            
            -
            
            
            
            9,000
            
            
            
            90
            
            
            
            30,915
            
            
            
            (28,951
            )
            
            
            (1,157
            )
            
            
            897Issuance
      of preferred stock
            
            
            43
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            3,386
            
            
            
            -
            
            
            
            -
            
            
            
            3,386Conversion
      of preferred
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -stock
      to common stock
            
            
            (9
            )
            
            
            -
            
            
            
            485
            
            
            
            5
            
            
            
            (5
            )
            
            
            -
            
            
            
            -
            
            
            
            -Preferred
      stock dividends paid
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (279
            )
            
            
            -
            
            
            
            -
            
            
            
            (279
            )Stock-based
      compensation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -expense
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            202
            
            
            
            -
            
            
            
            -
            
            
            
            202Common
      stock issued for
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -options
      exercised
            
            
            -
            
            
            
            -
            
            
            
            169
            
            
            
            2
            
            
            
            407
            
            
            
            -
            
            
            
            -
            
            
            
            409Tax
      benefit of options exercised
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            124
            
            
            
            -
            
            
            
            -
            
            
            
            124Common
      stock issued forservices
      provided
            
            
            
            
            
            
            
            
            
            
            22
            
            
            
            -
            
            
            
            96
            
            
            
            -
            
            
            
            -
            
            
            
            96Issuance
      of warrants
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,941
            
            
            
            -
            
            
            
            -
            
            
            
            1,941Common
      stock issued for
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -warrants
      exercised
            
            
            -
            
            
            
            -
            
            
            
            1,338
            
            
            
            13
            
            
            
            717
            
            
            
            -
            
            
            
            -
            
            
            
            730Foreign
      currency translation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -adjustment
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            201
            
            
            
            201Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (346
            )
            
            
            -
            
            
            
            (346
            )Balance, December 31,
      2006
            
            
            34
            
            
            $
            -
            
            
            
            11,014
            
            
            $
            110
            
            
            $
            37,504
            
            
            $
            (29,297
            )
            
            $
            (956
            )
            
            $
            7,361Issuance
      of common stock
            
            
            -
            
            
            
            -
            
            
            
            1,667
            
            
            
            17
            
            
            
            8,705
            
            
            
            -
            
            
            
            -
            
            
            
            8,722Conversion
      of preferred
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -stock
      to common stock
            
            
            (34
            )
            
            
            -
            
            
            
            1,916
            
            
            
            19
            
            
            
            (19
            )
            
            
            -
            
            
            
            -
            
            
            
            -Preferred
      stock dividends paid
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (49
            )
            
            
            -
            
            
            
            -
            
            
            
            (49
            )Stock-based
      compensation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -expense
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            344
            
            
            
            -
            
            
            
            -
            
            
            
            344Common
      stock issued for
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -options
      exercised
            
            
            -
            
            
            
            -
            
            
            
            617
            
            
            
            6
            
            
            
            1,677
            
            
            
            -
            
            
            
            -
            
            
            
            1,683Adjustment
      of tax benefit of options  exercised
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (115)
            
            
            
            -
            
            
            
            -
            
            
            
            (115)Common
      stock issued forservices
      provided
            
            
            -
            
            
            
            -
            
            
            
            30
            
            
            
            -
            
            
            
            229
            
            
            
            -
            
            
            
            -
            
            
            
            229Issuance
      of warrants
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            510
            
            
            
            -
            
            
            
            -
            
            
            
            510Common
      stock issued for
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -warrants
      exercised
            
            
            -
            
            
            
            -
            
            
            
            264
            
            
            
            3
            
            
            
            439
            
            
            
            -
            
            
            
            -
            
            
            
            442Foreign
      currency translation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -adjustment
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            69
            
            
            
            69Net
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,169
            
            
            
            -
            
            
            
            1,169Balance, December 31,
      2007
            
            
            -
            
            
            
            -
            
            
            
            15,508
            
            
            
            155
            
            
            
            49,225
            
            
            
            (28,128
            )
            
            
            (887
            )
            
            
            20,365The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-6


GSE SYSTEMS, INC. AND
      SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH
      FLOWS(in
      thousands)Years
      ended December 31,2007
              
              2006
              
              2005Cash flows from operating
      activities:Net
      income (loss)
              
              
              
              
              $         1,169
              
              $         (346)
              
              $     (4,795)Adjustments
      to reconcile net income (loss) to net cashprovided
      by (used in) operating activities:Depreciation
              
              
              
              
              258
              
              186
              
              431Capitalized
      software amortization
              
              
              
              323
              
              453
              
              452Note
      payable discount amortization
              
              
              
              -
              
              58
              
              203Deferred
      financing costs amortization
              
              
              533
              
              444
              
              35Stock-based
      compensation expense
              
              
              
              573
              
              298
              
              -Elimination
      of profit on Emirates Simulation Academy, LLC contract
              444
              
              251
              
              -Equity
      loss on investment in Emirates Simulation Academy, LLC
              
              54
              
              -
              
              -Foreign
      currency transaction (gain) loss
              
              
              60
              
              (128)
              
              35Change
      in fair market value of liabilities for conversion of options and
      warrants
              -
              
              -
              
              (636)Loss
      on extinguishment of debt
              
              
              
              -
              
              1,428
              
              -Deferred
      income taxes
              
              
              
              
              -
              
              -
              
              50Changes
      in assets and liabilities:Contract
      receivables
              
              
              
              (52)
              
              (3,773)
              
              1,827Prepaid
      expenses and other assets
              
              
              (416)
              
              (78)
              
              810Accounts
      payable, accrued compensation and accrued expenses
              
              (1,559)
              
              473
              
              (597)Due
      to GP Strategies Corporation
              
              
              -
              
              (536)
              
              251Billings
      in excess of revenues earned
              
              
              403
              
              690
              
              79Accrued
      warranty reserves
              
              
              
              (22)
              
              (8)
              
              87Other
      liabilities
              
              
              
              
              103
              
              (6)
              
              (25)Income
      taxes payable
              
              
              
              -
              
              -
              
              (58)Net cash provided by (used in)
      operating activities
              
              
              1,871
              
              (594)
              
              (1,851)Cash flows from investing
      activities:Investment
      in Emirates Simulation Academy, LLC
              
              
              (261)
              
              (238)
              
              -Restriction
      of cash as collateral under letters of credit or
guarantees
              (1,799)
              
              (2,298)
              
              (27)Capital
      expenditures
              
              
              
              
              (778)
              
              (185)
              
              (182)Capitalized
      software development costs
              
              
              (673)
              
              (333)
              
              (483)Net cash used in investing
      activities
              
              
              
              (3,511)
              
              (3,054)
              
              (692)Cash flows from financing
      activities:Increase
      (decrease) in borrowings under lines of credit
              
              (2,155)
              
              2,155
              
              1,182Payoff
      of line of credit with bank
              
              
              
              -
              
              (1,182)
              
              -Net
      proceeds from issuance of common stock and warrants
              
              9,232
              
              -
              
              -Net
      proceeds from issuance of preferred stock and warrants
              
              -
              
              3,856
              
              -Proceeds
      from issuance of common stock
              
              
              2,125
              
              1,139
              
              100Tax
      benefit from option exercises
              
              
              
              (115)
              
              124
              
              -Payment
      of preferred stock dividends
              
              
              
              (49)
              
              (279)
              
              -Payment
      of ManTech preferred stock dividends
              
              
              (316)
              
              -
              
              -Issuance
      (paydown) of subordinated convertible note payable
              
              -
              
              (2,000)
              
              2,000Deferred
      financing costs
              
              
              
              -
              
              (448)
              
              (232)Other
      financing activities, net
              
              
              
              -
              
              -
              
              (9)Net cash provided by financing
      activities
              
              
              8,722
              
              3,365
              
              3,041Effect
      of exchange rate changes on cash
              
              
              
              17
              
              35
              
              (45)Net increase (decrease) in cash
      and cash equivalents
              
              
              7,099
              
              (248)
              
              453Cash and cash equivalents at
      beginning of year
              
              
              1,073
              
              1,321
              
              868Cash and cash equivalents at
      end of period
              
              
              $      8,172
              
              $        1,073
              
              $       1,321The
      accompanying notes are an integral part of these consolidated financial
      statements.





F-7


GSE SYSTEMS, INC. AND
SUBSIDIARIES





NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS





December
31, 2007, 2006, and 2005




1.  Business and basis of
presentation





GSE
Systems, Inc. ("GSE Systems", “GSE” or the "Company") provides training
simulators and educational solutions to the energy, process, manufacturing and
government sectors.





On June
21, 2005, the Board of Directors of GP Strategies Corporation (“GP Strategies”)
approved plans to spin-off its 57% interest in GSE through a special dividend to
the GP Strategies’ stockholders.  On September 30, 2005, the GP
Strategies’ stockholders received 0.283075 share of GSE common stock for each
share of GP Strategies common stock or Class B stock held on the record date of
September 19, 2005.  Following the spin-off, GP Strategies ceased to
have any ownership interest in GSE.  GP Strategies continued to
provide corporate support services to GSE, including accounting, finance, human
resources, legal, network support and tax pursuant to a Management Services
Agreement which expired on December 31, 2006.





The
Company’s operations are subject to certain risks and uncertainties including,
among others, rapid technological changes, success of the Company’s product
development, marketing and distribution strategies, the need to manage growth,
the need to retain key personnel and protect intellectual property, and the
availability of additional financing on terms acceptable to the
Company.





At
December 31, 2007, the Company had cash and cash equivalents of $8.2 million and
another $2.3 million available under its line of credit.  The Company
anticipates that its cash on hand and its normal operations will
provide all of the funds necessary to fund its consolidated operations
during the next twelve months.  The Company believes that it will have
sufficient liquidity and working capital without additional
financing.  However, notwithstanding the foregoing, the Company may be
required to look for additional capital to fund its operations if the Company is
unable to operate profitably and generate sufficient cash from
operations.  There can be no assurance that the Company would be
successful in raising such additional funds.








2.  Summary of significant
accounting policies





Principles of
consolidation





The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All intercompany balances and
transactions have been eliminated.







Accounting
estimates





The preparation of financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting
period.  The Company’s most significant estimates relate to revenue
recognition, capitalization of software development costs, and the
recoverability of net deferred tax assets.  Actual results could
differ from those estimates.


F-8







Revenue
recognition





The
majority of the Company’s revenue is derived through the sale of uniquely
designed systems containing hardware, software and other materials under
fixed-price contracts.  In accordance with Statement of Position 81-1,
Accounting for Performance of
Construction-Type and Certain Production-Type Contracts, the revenue
under these fixed-price contracts is accounted for on the
percentage-of-completion method. This methodology recognizes revenue and
earnings aswork
progresses on the contract and is based on an estimate of the revenue and
earnings earned to date, less amounts recognized in prior
periods.  The Company bases its estimate of the degree of completion
of the contract by reviewing the relationship of costs incurred to date to the
expected total costs that will be incurred on the project. Estimated contract
earnings are reviewed and revised periodically as the work progresses, and the
cumulative effect of any change in estimate is recognized in the period in which
the change is identified. Estimated losses are charged against earnings in the
period such losses are identified.  The Company recognizes revenue
arising from contract claims either as income or as an offset against a
potential loss only when the amount of the claim can be estimated reliably and
realization is probable and there is a legal basis of the
claim.  There are no claims outstanding as of December 31,
2007.





As the
Company recognizes revenue under the percentage-of-completion method, it
provides an accrual for estimated future warranty costs based on historical and
projected claims experience.  The Company’s long-term contracts
generally provide for a one-year warranty on parts, labor and any bug fixes as
it relates to software embedded in the systems.





The
Company’s system design contracts do not normally provide for “post customer
support service” (PCS) in terms of software upgrades, software enhancements or
telephone support.  In order to obtain PCS, the customers must
normally purchase a separate contract.  Such PCS arrangements are
generally for a one-year period renewable annually and include customer support,
unspecified software upgrades, and maintenance releases.  The Company
recognizes revenue from these contracts ratably over the life of the agreements
in accordance with Statement of Position 97-2, Software Revenue
Recognition.





Revenue
from the sale of software licenses which do not require significant
modifications or customization for the Company’s modeling tools are recognized
when the license agreement is signed, the license fee is fixed and determinable,
delivery has occurred, and collection is considered probable.





Revenue
for contracts with multiple elements are recognized in accordance with Emerging
Issues Task Force Issue 00-21, Accounting for Revenue Arrangements
with Multiple Deliverables.





Revenues
from certain consulting or training contracts are recognized on a
time-and-material basis.  For time-and-material type contracts,
revenue is recognized based on hours incurred at a contracted labor rate plus
expenses.


F-9





Cash and cash
equivalents





Cash and
cash equivalents consist of cash on hand, overnight sweep investments, and
highly liquid investments with maturities of three months or less at the date of
purchase.




Contract
receivables





Contract
receivables include recoverable costs and accrued profit not billed which
represents revenue recognized in excess of amounts billed.  The
liability “Billings in excess of revenue earned” represents billings in excess
of revenue recognized.





Billed
receivables are recorded at invoiced amounts.  The allowance for
doubtful accounts is based on historical trends of past due accounts,
write-offs, and specific identification and review of past due
accounts.  The activity in the allowance for doubtful accounts is as
follows:





(in
      thousands)
              As
      of and for theYears
      ended December 31,2007
              
              2006
              
              2005Beginning
      balance
              $             3
              
              $             245
              
              $           24Current
      year provision
              -
              
              3
              
              496Current
      year write-offs
              (1)
              
              (245)
              
              (275)Ending
      balance
              $             2
              
              $                 3
              
              $         245


Equipment and leasehold
improvements, net





Equipment
is recorded at cost and depreciated using the straight-line method with
estimated useful lives ranging from three to ten years.  Leasehold
improvements are amortized over the life of the lease or the estimated useful
life, whichever is shorter, using the straight-line method.  Upon sale
or retirement, the cost and related amortization are eliminated from the
respective accounts and any resulting gain or loss is included in operations.
Maintenance and repairs are charged to expense as incurred.





Software development
costs





Certain
computer software development costs are capitalized in the accompanying
consolidated balance sheets in accordance with SFAS No. 86, Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise
Marketed.  Capitalization of computer software development
costs begins upon the establishment of technological feasibility. Capitalization
ceases and amortization of capitalized costs begins when the software product is
commercially available for general release to customers.  Amortization
of capitalized computer software development costs is included in cost of
revenue and is determined using the straight-line method over the remaining
estimated economic life of the product, not to exceed five
years.


F-10


Development
expenditures





Development
expenditures incurred to meet customer specifications under contracts are
charged to contract costs.  Company sponsored development expenditures
are charged to operations as incurred and are included in selling, general and
administrative expenses. The amounts incurred for Company sponsored development
activities relating to the development of new products and services or the
improvement of existing products and services, were approximately $1.2 million,
$871,000, and $758,000, for the years ended December 31, 2007, 2006, and 2005,
respectively.  Certain of these expenditures were capitalized as
software development costs.  See Note 6, Software development
costs.





Impairment of long-lived
assets





In
accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, property and equipment are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable.  Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to estimated undiscounted future cash flows; an impairment charge is
recognized by the amount by which the carrying amount of the asset exceeds the
fair value of the asset.  Assets to be disposed of would be separately
presented in the balance sheet and reported at the lower of the carrying amount
or fair value less costs to sell, and are no longer depreciated.  The
assets and liabilities of a disposal group classified as held for sale would be
presented separately in the appropriate asset and liability sections of the
balance sheet.





On an annual basis, and more frequently
as conditions indicate, the Company assesses the recovery of the unamortized
capitalized software computer costs by estimating the net undiscounted cash
flows expected to be generated by the sale of the product.  If the
undiscounted cash flows are not sufficient to recover the unamortized software
costs the Company will write-down the investment to its estimated fair value
based on future discounted cash flows.  The excess of any unamortized
computer software costs over the related net realizable value is written down
and charged to operations.





Goodwill
is tested annually, on November 30, for impairment, or more frequently if events
and circumstances indicate that the asset might be impaired.  An
impairment loss is recognized to the extent that the carrying amount exceeds the
asset’s fair value.  For goodwill, the impairment determination is
made at the reporting unit level and consists of two steps.  First,
the Company determines the fair value of a reporting unit and compares it to its
carrying amount.  Second, if the carrying amount of a reporting unit
exceeds its fair value, an impairment loss is recognized for any excess of the
carrying amount of the reporting unit’s goodwill over the implied fair value of
that goodwill.  The implied fair value of goodwill is determined by
allocating the fair value of the reporting unit in a manner similar to a
purchase price allocation, in accordance with SFAS No. 141, Business Combinations.The
residual fair value after this allocation is the implied fair value of the
reporting unit goodwill.  No impairment losses were recognized in
2007, 2006 and 2005.





Foreign currency
translation





Balance
sheet accounts for foreign operations are translated at the exchange rate at the
balance sheet date, and income statement accounts are translated at the average
exchange rate for the period.  The resulting translation adjustments
are included in other comprehensive income (loss).  Transaction gains
and losses, resulting from changes in exchange rates, are included in other
income (expense) in the Consolidated Statements of Operations in the period in
which they occur.  For the years ended December 31, 2007, 2006, and
2005, foreign currency transaction gains (losses) were approximately ($60,000),
$128,000, and ($35,000), respectively.


F-11




Warranty





As the
Company recognizes revenue under the percentage-of-completion method, it
provides an accrual for estimated future warranty costs based on historical
experience and projected claims.  The activity in the warranty
accounts is as follows:


(in
      thousands)
              As
      of and for theYears
      ended December 31,2007
              
              2006
              
              2005Beginning
      balance
              $               746
              
              $               754
              
              $               667Current
      year provision
              458
              
              568
              
              286Current
      year claims
              (483)
              
              (599)
              
              (166)Currency
      adjustment
              3
              
              23
              
              (33)Ending
      balance
              $               724
              
              $               746
              
              $               754


Income taxes





Deferred
income taxes are provided under the asset and liability method.  Under
this method, deferred income taxes are determined based on the differences
between the financial statement and tax bases of assets and liabilities using
enacted tax rates in effect for the year in which the differences are expected
to reverse.  Valuation allowances are established when necessary to
reduce deferred tax assets to the amounts expected to be realized. Provision is
made for the Company's current liability for federal, state and foreign income
taxes and the change in the Company's deferred income tax assets and
liabilities.




Stock-based
compensation




In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 123R, Share-Based Payment (SFAS No.
123R), which revises SFAS No. 123, Accounting for Stock-Based
Compensation(SFAS No. 123), and supersedes Accounting Principles Board
Opinion No. 25, Accounting for
Stock Issued to Employees (APB No. 25), and requires companies to
recognize compensation expense for all equity-based compensation awards issued
to employees that are expected to vest. The Company adopted SFAS No. 123R on
January 1, 2006, using the Modified Prospective Application method without
restatement of prior periods. Under this method, the Company would begin to
amortize compensation cost for the remaining portion of its outstanding awards
for which the requisite service was not yet rendered as of January 1, 2006.
However, at January 1, 2006, all of the Company’s outstanding options were fully
vested and thus there is no compensation expense in 2006 related to the adoption
of SFAS No. 123R on these outstanding options. The Company determines the fair
value of and accounts for awards that are granted, modified, or settled after
January 1, 2006 in accordance with SFAS No. 123R.




F-12






Compensation
expense related to share based awards is recognized on a straight-line basis
based on the value of share awards that are scheduled to vest during the
requisite service period.  During the twelve months ended December 31,
2007 and 2006, the Company recognized $344,000 and $202,000, respectively, of
pre-tax stock-based compensation expense under the fair value method in
accordance with SFAS No. 123R.  As of December 31, 2007, the Company
had $471,000 of unrecognized compensation related to the unvested portion of
outstanding stock option awards expected to be recognized through January
2010.





Prior to
2006, the Company applied the intrinsic-value-based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for stock issued to
Employees, and related interpretations including FASB Interpretation No.
44, Accounting for Certain
Transactions involving Stock Compensation, and interpretation of APB Opinion No.
25, issued in March 2000, to account for its fixed-plan stock
options.  Under this method, compensation expense was recorded on the
date of grant only if the current market price of the underlying stock exceeded
the exercise price.  SFAS No. 123, Accounting for Stock-Based
Compensation, established accounting and disclosure requirements using a
fair-value-based method of accounting for stock based employee compensation
plans.  As allowed by SFAS No. 123, the Company elected to continue to
apply the intrinsic-value-based method of accounting described above, and had
adopted only the disclosure requirements of SFAS No. 123.  See Note
12, Stock-Based compensation.




Income (loss) per
share





Basic income (loss) per share is based
on the weighted average number of outstanding common shares for the
period.  Diluted income (loss) per share adjusts the weighted average
shares outstanding for the potential dilution that could occur if stock options,
warrants, convertible subordinated debt or convertible preferred stock were
exercised or converted into common stock.  The number of common shares
and common share equivalents used in the determination of basic and diluted
income (loss) per share was as follows:


F-13


(in thousands, except for
      share and per share amounts)Years
      ended December 31,2007
              
              2006
              
              2005Numerator:Net
      income (loss)
              
              
              $           1,169
              
              $        (346)
              
              $      (4,795)Preferred
      stock dividends
              
              (49)
              
              (279)
              
              -Net
      income (loss) attributed tocommon
      stockholders
              
              $           1,120
              
              $        (625)
              
              $      (4,795)Denominator:Weighted-average
      shares outstanding for basicearnings
      per share
              
              12,927,128
              
              9,539,142
              
              8,999,021Effect
      of dilutive securities:Employee
      stock options, warrants andconvertible
      preferred stock
              
              1,890,525
              
              -
              
              -Adjusted
      weighted-average shares outstandingand
      assumed conversions for dilutedearnings
      per share
              
              14,817,653
              
              9,539,142
              
              8,999,021Shares
      related to dilutive securities excludedbecause
      inclusion would be anti-dilutive
              74,808
              
              3,755,457
              
              2,753,213


Conversion of the stock options,
warrants, convertible preferred stock and convertible subordinated debt was not
assumed for the years ended December 31, 2006 and 2005 because the impact was
anti-dilutive. The difference between the basic and diluted number of weighted
average shares outstanding for the year ended December 31, 2007 represents
dilutive stock options and warrants to purchase shares of common stock computed
under the treasury stock method, using the average market price during the
period.  The net income for the year ended December 31, 2007 was
decreased and the net loss for the year ended December 31, 2006 was increased by
preferred stock dividends of $49,000 and $279,000, respectively, in calculating
the per share amounts.





Concentration of credit
risk





The
Company is subject to concentration of credit risk with respect to contract
receivables. Credit risk on contract receivables is mitigated by the nature of
the Company's worldwide customer base and its credit policies.  The
Company's customers are not concentrated in any specific geographic region, but
are concentrated in the energy industry.  For the year ended December
31, 2007, the Emirates Simulation Academy, LLC (UAE) provided 31% of the
Company’s consolidated revenue (21% in 2006 and none in 2005); Rosenergoatom
Federal State Owned Enterprise (Russia) provided 9% of the Company’s
consolidated 2007 revenue (12% in 2006 and  none in 2005), and
Battelle’s Pacific Northwest National Laboratory accounted for approximately 4%
of the Company’s consolidated revenue (11% and 25% in 2006 and 2005,
respectively).   The Pacific Northwest National Laboratory is the
purchasing agent for the Department of Energy and the numerous projects the
Company performs in Eastern and Central Europe.As
of December 31, 2007, the contracts receivable balance related to these three
significant customers was approximately $4.6 million, or 43% of contract
receivables, of which $3.4 million was unbilled at year-end.


F-14




Fair values of financial
instruments





The
carrying amounts of current assets, current liabilities, and long-term debt
reported in the Consolidated Balance Sheets approximate fair value due to their
short term duration.





Deferred financing
fees





The Company amortizes the cost
incurred to obtain debt financing over the term of the underlying obligations
using the effective interest method.  The amortization of deferred
financing costs is included in interest expense.  Unamortized deferred
financing costs are classified within other assets in the consolidated balance
sheets.





Derivative
instruments





The
Company utilizes foreign currency forward financial instruments to manage market
risks associated with the fluctuations in foreign currency exchange rates. It is
the Company's policy to use derivative financial instruments to protect against
market risk arising in the normal course of business. The criteria the Company
uses for designating an instrument as a hedge include the instrument's
effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions.   The Company monitors
its foreign currency exposures to maximize the overall effectiveness of its
foreign currency hedge positions. Principal currencies hedged include the Pound
Sterling and the Japanese Yen. The Company's objectives for holding derivatives
are to minimize the risks using the most effective methods to reduce the impact
of these exposures. The Company minimizes credit exposure by limiting
counterparties to nationally recognized financial institutions.





All
derivatives, whether designated as hedging relationships or not, are recorded on
the balance sheet at fair value. If the derivative is designated as a fair value
hedge, the changes in the fair value of the derivative and of the hedged item
attributable to the hedged risk are recognized in earnings.  If the
derivative is designated as a cash flow hedge, the change in the fair value of
the derivative and of the hedged item are recognized as an element of other
comprehensive income.





As of December 31, 2007, the Company
had contracts for sale of approximately 36 million Japanese Yen and 125,000
Pounds Sterling at fixed rates. The contracts expire on various dates through
January 2008.  The Company has not designated the contracts as hedges
and has recorded the estimated fair value of the contracts of $1,000 and $11,000
as of December 31, 2007 and 2006, respectively, as an other asset in the
consolidated balance sheet.  The change in the estimated fair value of
the contracts for the years ended December 31, 2007, 2006 and 2005 was
approximately ($11,000), ($23,000), and ($170,000), respectively, and was
recorded in other income (expense) in the consolidated statements of
operations.




F-15


Accounting
standard adopted




In July
2006, the Financial Accounting Standards Board, or FASB, issued Interpretation,
or FIN, No. 48, Accounting for Uncertainty in Income
Taxes — An Interpretation of FASB Statement No. 109, “Accounting for Income
Taxes”. FIN No. 48
clarifies the accounting for uncertainty in income taxes recognized in our
financial statements. It also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of tax
positions taken or expected to be taken in a tax return. This interpretation
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods and expanded disclosure with respect to
uncertainty in income taxes. The Company adopted the guidance of FIN No. 48
effective January 1, 2007. The adoption of this accounting pronouncement
did not have a material effect on the Company’s financial position, results of
operations or cash flows. Furthermore, the Company is not aware of any tax
positions for which it is reasonably possible that the total amounts of
unrecognized tax benefits would significantly decrease or increase within the
next twelve months.




The
Company files in the United States federal jurisdiction and in several
state and foreign jurisdictions. Because of the net operating loss
carryforwards, the Company is subject to U.S. federal and state income tax
examinations from years 1997 and forward and is subject to foreign tax
examinations by tax authorities for years 2001 and forward. Open tax years
related to state and foreign jurisdictions remain subject to examination but are
not considered material to our financial position, results of operations or cash
flows.





As of December 31, 2007, there have
been no material changes to the liability for uncertain tax
positions.





New accounting
standards




In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement No. 157, Fair
Value Measurements(“SFAS 157”).
SFAS 157 defines fair value, establishes a framework for measuring fair
value and expands disclosure requirements regarding fair value measurements.
SFAS 157 does not require any new fair value measurements. However, on
February 12, 2008 the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No.
157 (“FSP FAS 157-2”).  FSP FAS 157-2 delays the effective date
of SFAS 157 for all nonfinancial assets and nonfinancial liabilities until
fiscal years beginning after November 15, 2008 and interim periods within those
fiscal years.  The Company does not believe the adoption of this
standard will have a material effect on its financial position, results of
operations or cash flows.




In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial
Assets and Liabilities--- Including an Amendment of FASB Statement No. 115(“SFAS 159”), which permits entities to measure eligible items at fair
value.  For items where the fair value election is made, the Company
will be required to report unrealized gains or losses in
earnings.  Statement 159 is effective January 1, 2008.  The
Company is currently assessing the impact the adoption of this statement will
have on our consolidated financial statements.








F-16


In
December, 2007, the FASB issued SFAS No. 141(R), Business Combinations
(“SFAS 141(R)”), which applies prospectively to business combinations for
which the acquisition date is on or after the beginning of the first annual
reporting period beginning on or after December 15, 2008. An entity may not
apply it before that date. SFAS 141(R) establishes principles and
requirements for how the acquirer: i) recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed
and any noncontrolling interest in the acquiree; ii) recognizes and
measures the goodwill acquired in the business combination or a gain from a
bargain purchase; and iii) determines what information to disclose to
enable users of the financial statements to evaluate the nature and financial
effects of the business combination. The Company does not expect the adoption of
SFAS 141 (R) to have an effect on its results of operations and its
financial condition unless it enters into a business combination after
January 1, 2009.





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research
Bulletin No. 51 (“SFAS 160”). SFAS 160 establishes
accounting and reporting standards for ownership interests in subsidiaries held
by parties other than the parent, the amount of consolidated net income
attributable to the parent and to the noncontrolling interest, changes in a
parent’s ownership interest and the valuation of retained noncontrolling equity
investments when a subsidiary is deconsolidated. SFAS 160 also establishes
disclosure requirements that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling owners. The
Company is required to adopt the provisions of SFAS 160 effective January 1,
2009.  The Company is currently evaluating the potential impact, if
any, of the adoption of SFAS 160 on its consolidated financial
operations.








3.  Contract
receivables





Contract
receivables represent balances due from a broad base of both domestic and
international customers. All contract receivables are considered to be
collectible within twelve months. Recoverable costs and accrued profit not
billed represent costs incurred and associated profit accrued on contracts that
will become billable upon future milestones or completion of
contracts.  The components of contract receivables are as
follows:





(in
      thousands)
              
              
              
              December
      31,2007
              
              2006Billed
      receivables
              
              
              
              $     4,160
              
              $       6,066Recoverable
      costs and accrued profit not billed
              
              6,563
              
              4,606Allowance
      for doubtful accounts
              
              
              (2)
              
              (3)Total
      contract receivables
              
              
              $   10,721
              
              $     10,669







F-17


4.  Prepaid expenses and other current
assets




Prepaid
expenses and other current assets consist of the following:


(in
      thousands)
              
              
              
              December
      31,2007
              
              2006Prepaid
      expenses
              
              
              
              $          531
              
              $          218Employee
      advances
              
              
              
              80
              
              26Other
      current assets
              
              
              
              283
              
              250Total
              
              
              
              
              $          894
              
              $          494


5.  Equipment and leasehold
improvements





Equipment
and leasehold improvements consist of the following:




(in
      thousands)
              
              
              
              December
      31,2007
              
              2006Computer
      equipment
              
              
              
              $    3,253
              
              $       2,422Leasehold
      improvements
              
              
              
              34
              
              4Furniture
      and fixtures
              
              
              
              508
              
              4463,795
              
              2,872Accumulated
      depreciation
              
              
              
              (2,915)
              
              (2,518)Equipment
      and leasehold improvements, net
              
              $       880
              
              $          354


Depreciation
expense was approximately $258,000, $186,000, and $431,000 for the years ended
December 31, 2007, 2006, and 2005, respectively.








6.  Software development
costs





Software
development costs, net, consist of the following:





(in
      thousands)
              
              
              
              December
      31,2007
              
              2006Capitalized
      software development costs
              
              
              $       1,555
              
              $       1,600Accumulated
      amortization
              
              
              
              (385)
              
              (780)Software
      development costs, net
              
              
              $       1,170
              
              $          820


Software development costs capitalized
were approximately $673,000, $333,000, and $483,000 for the years ended December
31, 2007, 2006 and 2005, respectively.  Amortization of software
development costs capitalized was approximately $323,000, $453,000, and
$452,000, for the years ended December 31, 2007, 2006 and 2005,
respectively, and was included in cost of revenue.







F-18


7.  Investment in Emirates
Simulation Academy, LLC





On
November 8, 2005, the Emirates Simulation Academy, LLC (“ESA”), headquartered in
Abu Dhabi, United Arab Emirates,  was formed to build and operate
simulation training academies in the Arab Gulf Region.  These
simulation training centers will be designed to train and certify indigenous
workers for deployment to critical infrastructure facilities including power
plants, oil refineries, petro-chemical plants, desalination units and other
industrial facilities.  The members of the limited liability company
include Al Qudra Holding PJSC of the United Arab Emirates (60% ownership), the
Centre of Excellence for Applied Research and Training of the United Arab
Emirates (30% ownership) and GSE (10% ownership).  At December 31,
2007 and 2006, GSE’s investment in ESA totaled $445,000 and $238,000,
respectively, and was included on the consolidated balance sheet in other
assets.  The Company accounts for its investment in ESA using the
equity method.  For the year ended December 31, 2007, the Company
recognized a $54,000 equity loss on its investment in ESA.  The equity loss
was recorded in other income (expense), net.





In
January 2006, GSE received a $15.1 million contract from ESA (the “ESA
Contract”) to supply five simulators and an integrated training program. A
$1.7 million change order was received from ESA in late 2007 increasing the
total order value to $16.8 million. For the years ended December 30, 2007 and
2006, the Company recognized $9.9 million and $5.7 million, respectively, of
contract revenue on this project using the percentage-of-completion method,
which accounted for 31.2% and 20.7% of the Company’s consolidated
revenue.   The ESA Contract is expected to be substantially
complete in early 2008.  In accordance with the equity method of
accounting, the Company has eliminated 10% of the profit from the ESA Contract
as the training simulators are assets that will be recorded on the books of ESA,
and the Company is thus required to eliminate its proportionate share of the
profit included in the asset value.  The profit elimination totaled
$444,000 and $251,000 for the year ended December 31, 2007, respectively, and
has been recorded as an other expense in the income statement and as an other
liability on the balance sheet.   Once ESA begins to amortize the
training simulators on their books, GSE will begin to amortize the other
liability to other income.





At
December 31, 2007 and 2006, the Company had trade receivables from ESA totaling
$1.0 million and $1.7 million, respectively.  In addition, the Company
had an unbilled receivable of $2.8 million and $1.9 million for the ESA Contract
at December 31, 2007 and 2006, respectively.  Under the terms of the
ESA Contract, the Company provided a $2.1 million performance bond to ESA that
will remain outstanding until October 31, 2008.   The Company has
deposited $1.2 million into a restricted, interest-bearing account at the Union
National Bank (“UNB”) in the United Arab Emirates as a partial guarantee for the
$11.8 million credit facility that UNB has extended to ESA.  The
guarantee will be in place until the expiration of the ESA credit facility on
December 31, 2014 or earlier if ESA pays down and terminates the credit
facility.








8.  Long-term
debt





At
December 31, 2007, and 2006, the Company had no long-term debt.





F-19


Line of Credit
 
 As of December 31, 2007, the Company
has a $5.0 million line of credit with Laurus Master Fund, Ltd. (the “Credit
Facility”). The line is collateralized by substantially all of the
Company’sassets and provides for borrowings up to 90% of eligible billed
accounts receivable, and 40% of eligible unbilled receivables (up to a maximum
of $1.0 million).  The interest rate on this line of credit is based
on the prime rate plus 200-basis points (9.25% as of December 31, 2007), with
interest only payments due monthly.  There are no fixed financial
ratios established as a term under the Credit Facility.  Because the
Laurus Credit Facility agreement includes both a subjective acceleration clause
and a requirement to maintain a lock-box arrangement whereby remittances for
GSE’s customers reduce the outstanding debt, any borrowings under the Credit
Facility would be classified as short-term obligations on the balance
sheet.  On May 18, 2006, Laurus Master Fund agreed to temporarily
increase the Company’s borrowing capability by $2.0 million over and above the
funds that were available to the Company based upon its normal borrowing base
calculation.  The over advance was used to collateralize a $2.1
million performance bond that the Company issued to ESA in the form of a standby
letter of credit.  One half of the increased borrowing capability
expired on July 18, 2006 and the balance expired on May 11, 2007.  The
Company’s borrowings over and above the normal borrowing base calculation bore
additional interest of 1.5% per month over and above the normal interest rate on
the line of credit.  At December 31, 2007, the Company’s available
borrowing base was $2.3 million, none of which had been utilized. The Credit
Facility expired on March 6, 2008.





Senior Convertible Secured
Subordinated Note Payable





On May 26, 2005, GSE issued and sold
to Dolphin Direct Equity Partners, LP (“Dolphin”) a Senior Subordinated Secured
Convertible Note in the aggregate principal amount of $2,000,000 which was to
mature on March 31, 2009 (the “Dolphin Note”), and a seven-year warrant to
purchase 380,952 shares of GSE common stock at an exercise price of $2.22 per
share (the “GSE Warrant”).  The Dolphin Note was convertible into
1,038,961 shares of GSE common stock at an exercise price of $1.925 per share
and accrued interest at 8% payable quarterly.





On February 28, 2006, the Company and
Dolphin entered into a Cancellation and Warrant Exchange Agreement (the
“Cancellation Agreement”) under which Dolphin agreed to cancel its Senior
Subordinated Secured Convertible Promissory Note and cancel its outstanding
warrant to purchase 380,952 shares of GSE common stock at an exercise price of
$2.22 per share.   In exchange for Dolphin’s agreement to enter
into the Cancellation Agreement, the Company repaid the Dolphin Note and agreed
to issue a new warrant to purchase 900,000 shares of GSE common stock at an
exercise price of $.67 per share (the “Dolphin Warrant”).  At the date
of issuance, the fair value of the Dolphin Warrant was $868,000, as established
using the Black-Scholes Model, and was recorded in paid-in capital with the
offset recorded as loss on extinguishment of debt.  In accordance with
the terms of the warrant agreement, Dolphin exercised the Dolphin Warrant on
November 8, 2006 upon the Company’s certification that, among other things, the
underlying shares of GSE common stock were registered with the Securities and
Exchange Commission on October 31, 2006, that the current stock price was
greater than $1.25 per share, and that the average of the current stock prices
for each trading day of the prior 30 calendar day period was not less than $1.25
per share.  The Company received cash proceeds of
$603,000.





In
conjunction with the early payoff of the Dolphin Note and the cancellation of
the 380,952 warrants, the Company wrote off the remaining unamortized Original
Issue Discount of $1.1 million, wrote off the remaining unamortized deferred
financing charges of $185,000; recognized a credit of $698,000 from the
write-off of the liabilities related to the Dolphin Note conversion feature and
the related warrants and took an $868,000 charge for the value of the 900,000
new warrants issued to Dolphin.   The total loss on
extinguishment of the Dolphin Note and the cancellation of the related warrants
totaled $1.4 million.


F-20







9.  Income
taxes





The
consolidated income (loss) before income taxes, by domestic and foreign sources,
is as follows:





(in
      thousands)
              
              Years
      ended December 31,2007
              
              2006
              
              2005Domestic
              
              
              $       1,496
              
              $          (466)
              
              $     (3,733)Foreign
              
              
              (284)
              
              269
              
              (913)Total
              $       1,212
              
              $          (197)
              
              $     (4,646)


The provision for income taxes is as
follows:






(in
      thousands)
              
              Years
      ended December 31,2007
              
              2006
              
              2005Current:Federal
              
              
              $            (111)
              
              $          103
              
              $              -State
              
              
              7
              
              29
              
              (4)Foreign
              
              
              147
              
              17
              
              103Subtotal
              
              43
              
              149
              
              99Deferred:Federal
      and state
              
              -
              
              -
              
              -Foreign
              
              
              -
              
              -
              
              50Subtotal
              
              -
              
              -
              
              50Total
              
              
              $         43
              
              $          149
              
              $          149


The
Company is entitled to a deduction for federal and state tax purposes with
respect to employees’ stock option activity.  The net reduction in
taxes otherwise payable in excess of any amount credited to income tax benefit
has been credited to additional paid-in capital.  As of December 31,
2007, the Company had $3.9 million of unrecognized excess tax deductions related
to compensation for stock option exercises which will be recognized when the net
operating loss carryforwards are fully utilized and those excess tax benefits
result in a reduction to income taxes payable.





The
effective income tax rate differed from the statutory federal income tax rate
due to the following:


F-21


Effective
      Tax Rate Percentage (%)Years
      ended December 31,2007
              
              2006
              
              2005Statutory
      federal income tax rate
              34.0
              %
              (34.0)
              %
              (34.0)
              %State
      income taxes, net of federal tax benefit
              0.4
              
              9.8
              
              -Effect
      of foreign operations
              
              16.2
              
              (2.3)
              
              3.1Change
      in valuation allowance
              (42.0)
              
              (95.2)
              
              34.0Other,
      principally permanent differences
              (5.1)
              
              197.6
              
              0.1Effective
      tax rate
              
              3.5
              %
              75.9
              %
              3.2
              %


Included
within permanent differences in 2006 are certain elements of the loss on
extinguishment of debt (see Note 8) that are not tax deductible.





Deferred income taxes arise from
temporary differences between the tax bases of assets and liabilities and their
reported amounts in the financial statements.  A summary of the tax
effect of the significant components of the deferred income tax assets
(liabilities) is as follows:





(in
      thousands)
              
              
              
              December
      31,2007
              
              2006
              
              2005Deferred
      tax assets:Net
      operating loss carryforwards
              
              $     6,799
              
              $     7,611
              
              $     8,035Investments
              
              
              
              1,584
              
              1,658
              
              1,658Foreign
      tax credits
              
              
              -
              
              378
              
              378Accruals
      and reserves
              
              
              31
              
              192
              
              138Expenses
      not currently deductible for tax purposes
              264
              
              300
              
              449Alternative
      minimum tax credit carryforwards
              162
              
              162
              
              162Other
              
              
              
              479
              
              179
              
              (107)Total
      deferred tax asset
              
              9,319
              
              10,480
              
              10,713Valuation
      allowance
              
              
              (8,868)
              
              (10,173)
              
              (10,361)Total
      deferred tax asset less valuation allowance
              451
              
              307
              
              352Deferred
      tax liabilities:Tax
      in excess of book depreciation
              
              -
              
              (6)
              
              (7)Software
      development costs
              
              (451)
              
              (301)
              
              (345)Total
      deferred tax liabilities:
              
              (451)
              
              (307)
              
              (352)Net
      deferred tax asset
              
              $          -
              
              $          -
              
              $          -
   In assessing the realizability of
deferred tax assets, management considers whether it is more likely than not
that some or all of the deferred tax assets will not be realized. The ultimate
realization of deferred tax assets is dependent upon the generation of future
taxable income during the periods in which those temporary differences become
deductible.  Management considers the scheduled reversal of deferred
tax liabilities and projected future income in making this assessment. Management
believes that the Company will achieve profitable operations in future years
that will enable the Company to recover the benefit of its net deferred tax
assets. However, the Company presently does not have sufficient objective
evidence to support management’s belief, and accordingly,
the Company has established an $8,868,000 valuation allowance for the deferred
tax assets as of December 31, 2007.  The valuation allowance for
deferred tax assets decreased by $1.3 million in 2007 and $188,000 in 2006, and
increased by $1,628,000 in 2005.


F-22







At December 31, 2007, the Company’s
largest deferred tax asset related to a U.S. net operating loss carryforward of
$17.2 million which expires in various amounts between 2017 and
2025.  The amount of U.S. loss carryforward which can be used by the
Company each year is limited due to changes in the Company’s ownership which
occurred in 2003.  Thus, a portion of the Company’s loss carryforward
may expire unutilized.





The Company adopted the provisions of
FIN 48 on January 1, 2007. There was no material impact on our results of
operations or financial position as a result of the implementation of FIN
48.  Furthermore, the Company is not aware of any tax positions for
which it is reasonably possible that the total amounts of unrecognized tax
benefits would significantly decrease or increase within the next twelve
months.





The Company’s policy for recording
interest and penalties associated with uncertain tax postitions is to
record such items as a component of income before taxes.  As of
December 31, 2007, the Company has no accrued interest or
penalties.








10.  Capital
stock





The Company’s Board of Directors has
authorized 32,000,000 total shares of capital stock, of which 30,000,000 are
designated as common stock and 2,000,000 are designated as preferred stock. At a
special shareholder’s meeting on December 13, 2007, the Company’s shareholders
approved an amendment to the Certificate of Incorporation increasing GSE’s
authorized common stock by 12 million shares to a total of 30 million
shares.  The Board of Directors has the authority to establish one or
more classes of preferred stock and to determine, within any class of preferred
stock, the preferences, rights and other terms of such class.





On June
22, 2007, the Company raised $9.2 million, net of associated fees of $768,000,
through the sale of 1,666,667 shares (the “Shares”) of its common stock, $.01
par value per share, by means of a private placement to selected institutional
investors.  Each investor received a five-year warrant to purchase GSE
common stock (the “Warrant Shares”) equal to 10% of the shares of common stock
that they had purchased at an exercise price of $6.00 per share (the
“Warrants”).  In aggregate, the Company issued Warrants to purchase a
total of 166,667 shares of GSE common stock.





The
Company filed its registration statement on Form S-3 (the “Registration
Statement”) with the Securities and Exchange Commission (the “Commission”) on
July 16, 2007 covering the offer and sale, from time to time, of the Shares, the
Warrant Shares and shares of common stock issuable upon exercise of warrants
that may be issued as liquidated damages under the terms of a certain
registration rights agreement entered into between the Company and the investors
(the “Registration Rights Agreement”) in connection with the private
placement.  The Registration Statement became effective on August 8,
2007 and, pursuant to the provisions of the Registration Rights Agreement, the
Company is obligated to use commercially reasonable efforts to, after the date
on which the Registration Statement becomes effective, cause the Registration
Statement to remain continuously effective as to all Shares and Warrant Shares,
other than for an aggregate of more than 30 consecutive trading days or for more
than an aggregate of 60 trading days in any 12-month
period. In the event of a default of the foregoing obligation, the Company will
be required to issue to the investors, as liquidated damages, on the date the
foregoing default occurs and each monthly anniversary thereafter, a number of
warrants (on the same terms as the Warrants) equal to 2% of the number of Shares
then held by such investor, not to exceed 10% of the total number of Shares then
held by such investor, and thereafter cash, in an amount equal to 2% of the
aggregate purchase price paid by the investors, not to exceed 30% of the
aggregate purchase price paid by the investors.


F-23





At the
date of issuance, the fair value of the Warrants was $510,000 and the fair value
of the Shares was $9.5 million.   The fair value of the Warrants
and the Shares was determined by the use of the relative fair value method, in
which the $10.0 million gross proceeds was allocated based upon the fair values
of the Warrants, as determined by using the Black-Scholes Model, and the Shares,
as determined by the closing price of the common stock on the American Stock
Exchange on the date the transaction was closed.





The
Company paid the placement agent a fee in the amount of 6% of the gross proceeds
received by the Company from the offering ($600,000).  In addition to
the placement agent fee, the Company paid $168,000 of other transaction fees
related to the offering.





The proceeds were used to pay down
the Company’s line of credit and for other working capital
purposes.





As of
December 31, 2007, the Company has reserved 3,275,838 shares of common stock for
issuance: 1,740,152 upon exercise of outstanding stock options and warrants;
1,346,795 for future grants under the Company’s 1995 Long-Term Incentive Plan;
22,224 shares to be issued in accordance with the Company’s investor relations
consulting agreement; and 166,667 shares upon exercise of warrants that the
Company is obligated to issue in the event of a default of under its June 2007
common stock sale as discussed above.








11.  Series A Convertible
Preferred Stock





On February 28, 2006, the Company
raised $3.9 million, net of associated fees of $395,000, through the sale of
42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by
means of a private placement to “accredited investors”, as that term is used in
rules and regulations of the Securities and Exchange Commission.  The
Convertible Preferred Stock was convertible at any time into a total of
2,401,133 shares of GSE common stock at a conversion price of $1.77 per share.
The conversion price was equal to 110% of the closing price of the Company’s
Common Stock on February 28, 2006, the date the sale of the Convertible
Preferred Stock was completed.





Each investor received a five-year
warrant to purchase GSE common stock equal to 20% of the shares they would
receive from the conversion of the Convertible Preferred Stock, at an exercise
price of $1.77.  In aggregate, the Company issued warrants to purchase
a total of 480,226 shares of GSE common stock.  The Convertible
Preferred Stockholders were entitled to an 8% cumulative dividend, payable on a
semiannual basis every June 30 and December 30.  In 2007 and 2006, the
Company paid dividends totaling $49,000 and $279,000, respectively, to the
preferred stockholders.   At the date of issuance, the fair value
of the warrants was $342,000 and the fair value of the preferred stock was $3.9
million. The fair value of the warrants and the preferred stock was determined
by the use of the relative fair value method, in which the $4.25 million gross
proceeds was allocated based upon the fair values of the warrants, as determined
by using the Black-Scholes Model, and the preferred stock, as determined by an
independent appraisal.


F-24







At any time after March 1, 2007, the
Company had the right to convert the Preferred Stock into shares of GSE common
stock when the average of the current stock price during the twenty trading days
immediately prior to the date of such conversion exceeded 200% of the Series A
Conversion Price.  On March 7, 2007, the Company sent notice to the
holders of the remaining 20,000 outstanding shares of its Preferred Stock that
the average current stock price for the prior twenty trading days had exceeded
200% of the Conversion Price, and that the Company was converting the
outstanding Preferred Stock into common stock.  The 20,000 shares of
Preferred Stock converted to 1,129,946 shares of GSE common
stock.  Prior to March 7, 2007, the holders of 22,500 shares of
Preferred Stock had already elected to convert their Preferred Stock into a
total of 1,271,187 shares of Common Stock; 8,580 shares of Preferred Stock were
converted in 2006 and 13,920 shares of preferred Stock in 2007.  In
2007 and 2006, the Preferred Stockholders exercised 62,147 and 28,248 warrants,
respectively.





The Company paid the placement agent,
as part of its fee for assisting the Company with the offering, 6% of the gross
proceeds received by the Company from the offering ($255,000) plus five-year
warrants to purchase 150,000 shares of the Company’s common stock at an exercise
price of $1.77 per share. In addition to the placement agent fee, the Company
paid $140,000 of other transaction fees related to the offering.  At
the date of issuance, the fair value of the placement agent warrants was
$128,000, as established using the Black-Scholes Model, and was recorded in
paid-in capital, with the offset recognized as a reduction of the preferred
stock proceeds.  In 2007 and 2006, 97,000 and 43,000, respectively, of
the placement agent warrants were exercised.





On
October 23, 2003, ManTech converted all of its preferred stock to common stock
in conjunction with the sale of its ownership in GSE to GP Strategies
Corporation (“GP Strategies”).  The Company had accrued dividends
payable to ManTech of $316,000 as of December 31, 2006.  The dividends
were paid in full to ManTech in June 2007 as well as interest that had accrued
on the dividends of $89,000.  The unpaid dividends accrued interest at
6% per annum.








12.  Stock-based
compensation





In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 123R, Share-Based Payment (SFAS No.
123R), which revises SFAS No. 123, Accounting for Stock-Based
Compensation(SFAS No. 123), and supersedes Accounting Principles Board
Opinion No. 25, Accounting for
Stock Issued to Employees (APB No. 25), and requires companies to
recognize compensation expense for all equity-based compensation awards issued
to employees that are expected to vest. The Company adopted SFAS No. 123R on
January 1, 2006, using the Modified Prospective Application method without
restatement of prior periods. Under this method, the Company would begin to
amortize compensation cost for the remaining portion of its outstanding awards
for which the requisite service was not yet rendered as of January 1, 2006.
However, at January 1, 2006, all of the Company’s outstanding options were fully
vested and thus there is no compensation expense in 2006 related to the adoption
of SFAS No. 123R on these outstanding options. The Company determines the fair
value of and accounts for awards that are granted, modified, or settled after
January 1, 2006 in accordance with SFAS No. 123R.




F-25


Long-term incentive
plan




During 1995, the Company established
the 1995 Long-Term Incentive Stock Option Plan (the “Plan”), which permits the
granting of stock options (including incentive stock options and nonqualified
stock options) stock appreciation rights, restricted or unrestricted stock
awards, phantom stock, performance awards or any combination of these to
employees, directors or consultants.  All options to purchase shares
of the Company’s common stock under the Plan expire seven years from the date of
grant and generally become exercisable in three installments with 40% vesting on
the first anniversary of the grant date and 30% vesting on each of the second
and third anniversaries of the grant date, subject to acceleration under certain
circumstances. At the Special  Meeting of Stockholders held on
December 31, 2007, the shareholders approved amendments to the Plan which
extended the life of the plan ten years to June 30, 2018 and increased the
number of shares that could be issued under the Plan to 3,500,000 from
2,500,000.   As of December 31, 2007, the Company had 1,346,795
shares of common stock reserved for future grants under the Plan.





Under
SFAS No. 123R, the Company recognizes compensation expense on a straight-line
basis over the requisite service period for stock-based compensation awards with
both graded and cliff vesting terms.  The Company applies a forfeiture
estimate to compensation expense recognized for awards that are expected to vest
during the requisite service period, and revises that estimate if subsequent
information indicates that the actual forfeitures will differ from the
estimate.  The Company recognizes the cumulative effect of a change in
the number of awards expected to vest in compensation expense in the period of
change.  The Company has not capitalized any portion of its
stock-based compensation.





During
the years ended December 31, 2007 and 2006, the Company recognized $344,000 and
$202,000, respectively of pre-tax stock-based compensation expense under the
fair value method in accordance with SFAS No. 123R.








Stock option and warrant
activity





During
the year ended December 31, 2007, the Company granted stock options to purchase
82,500 shares of common stock to GSE directors, officers, and
employees.  In addition, each investor in the Common Stock transaction
discussed in Note 11 received a five-year warrant to purchase GSE common stock
equal to 10% of the shares of common stock that they had purchased at an
exercise price of $6.00 per share.  In aggregate, the Company issued
Warrants to purchase a total of 166,667 shares of GSE common
stock.  The warrants vested immediately.






F-26


Information with respect to stock option and warrant
activity and stock options and warrants outstanding at December 31, 2007, 2006
and 2005 is as follows:   AggregateNumber
              
              Weighted
              
              Intrinsicof
              
              Average
              
              ValueShares
              
              Exercise
      Price
              
              (in
      thousands)Shares
      under option and warrant, January 1, 2005
              
              1,891,776
              
              $                    3.96Options
      and warrants granted
              
              980,952
              
              1.99Options
      and warrants exercised
              
              (50,000)
              
              2.00
              
              $                 37Options
      and warrants canceled
              
              (281,598)
              
              6.91Shares
      under option and warrant, December 31, 2005
              
              2,541,130
              
              $                    2.90Options
      and warrants granted
              
              2,557,873
              
              1.13Options
      and warrants exercised
              
              (1,507,146)
              
              0.76
              
              $            4,285Options
      and warrants canceled
              
              (972,677)
              
              3.06Shares
      under option and warrant, December 31, 2006
              
              2,619,180
              
              $                    2.34
              
              $            6,075Options
      and warrants granted
              
              249,167
              
              6.76Options
      and warrants exercised
              
              (880,586)
              
              2.41
              
              $            5,334Options
      and warrants canceled
              
              (247,609)
              
              5.11Shares
      under option and warrant, December 31, 2007
              
              1,740,152
              
              $                    2.54
              
              $          13,392Options
      and warrants exercisable at December 31, 2007
              1,264,152
              
              $                    2.41
              
              $            9,895




F-27


A summary of the status of the Company’s nonvested options
and warrants as of and for the years ended December 31, 2007 and 2006 is
presented below:





WeightedNumber
            
            Averageof
      Shares
            
            Fair
      ValueNonvested
      options and warrants at January 1, 2006
            -
            
            $                -Options
      and warrants granted
            
            2,557,873
            
            1.05Options
      and warrants vested during the period
            (1,897,873)
            
            1.02Options
      and warrants canceled and expired
            -
            
            -Nonvested
      options and warrants at December 31, 2006
            660,000
            
            $            1.13Options
      and warrants granted
            
            249,167
            
            4.14Options
      and warrants vested during the period
            (433,167)
            
            2.07Options
      and warrants canceled and expired
            -
            
            -Nonvested
      options and warrants at December 31, 2007
            476,000
            
            $            1.86


Information
concerning shares under stock options and warrants exercisable and shares under
stock options expected to vest at December 31, 2007:





WeightedAverage
              
              
              
              AggregateRemaining
              
              Weighted
              
              IntrinsicOptions
              
              Contractual
      Life
              
              Average
              
              ValueExercisable
              
              (Years)
              
              Exercise
      Price
              
              (in
      thousands)Stock
      options and warrants exercisable
              1,264,152
              
              3.52
              
              2.41
              
              $            9,895Stock
      options expected to vest
              476,000
              
              5.37
              
              2.89
              
              $            3,497Shares
      under options and warrants exercisableand
      expected to vest
              1,740,152




F-28


The fair value of the options and warrants granted
in 2007 and 2006 were estimated on the date of grant using a Black-Scholes
option-pricing model with the following assumptions:





Year
      ended December 31,2007
            
            2006Risk-
      free interest rates
            4.77%-5.02%
            4.73%
      - 4.99%Dividend
      yield
            0%
            
            0%Expected
      life
            3.2
      - 5.4 years
            5.0
      yearsVolatility
            70.54%
      - 71.99%
            72.88%
      - 73.97%Weighted
      Average Volatility
            71.02%
            
            73.90%





As of
December 31, 2007, the Company had $471,000 of unrecognized compensation expense
related to the unvested portion of outstanding stock options expected to be
recognized through January 2010.





Pro-forma
information





The
following table presents the pro-forma effect on net income and earnings per
share for all outstanding stock-based compensation awards for the year ended
December 31, 2005 in which the fair value provisions of SFAS No. 123R were not
in effect:





(in
      thousands, except per share data)
              
              Year
      endedDecember
      31, 2005Net
      income (loss) attributed tocommon
      stockholders, as reported
              
              $                        (4,795)Add
      stock-based employee compensation expenseincluded
      in reported net loss
              
              -Deduct
      total stock-based employee compensationexpense
      determined under fair-value-methodfor
      all awards, net of tax
              
              (672)Pro
      forma net loss
              
              $                        (5,467)Net
      loss per share, as reported:Basic
              
              $                          (0.53)Diluted
              
              $                          (0.53)Net
      loss per share, proforma:Basic
              
              $                          (0.61)Diluted
              
              $                          (0.61)














F-29




The fair
value of each option was estimated on the date of grant using a Black-Scholes
option-pricing model with the following weighted-average
assumptions:


Year
      endedDecember
      31, 2005Risk-
      free interest rate
              4.0%Dividend
      yield
              0.0%Expected
      life
              4.4
      yearsVolatility
              74.6%


Common stock issued for services
provided





In April
2006, the Company entered into a consulting agreement with an investor relations
firm.  As partial compensation for services rendered pursuant to the
consulting agreement, the Company agreed to issue 50,000 shares of common
stock.  The shares vested in monthly increments of 2,778 shares
commencing May 2006 and ending October 2007.  The Company delivered
the 50,000 common shares to the investor relations firm in October 2007. The
consulting agreement was extended for an additional eighteen months from
November 2008 through April 2010, and an additional 25,000 shares of common
stock will be issued as partial compensation for services rendered, with the
shares vesting in monthly increments of 1,388
shares.   Compensation expense is determined based on the price
per share on the last day of each month.   For the year ended
December 31, 2007, the average price per share was $7.79 and the total
compensation expense recognized by the Company was $229,000.  For the
eight months ending December 31, 2006, the average price per share was $4.34;
the total compensation expense recognized by the Company was $96,000 in the
twelve months ended December 31, 2006.








13.  Commitments and
contingencies





Leases





The
Company is obligated under certain noncancelable operating leases for office
facilities and equipment.  Future minimum lease payments under
noncancelable operating leases as of December 31, 2007 are as
follows:





(in
thousands)
              Gross
    Future
              
              Assignment
              
              Net
    FutureMinimum
      Lease
              
              of
              
              Minimum
      LeasePayments
              
              Lease
              
              Payments2008
              
              $                1,015
              
              $          (285)
              
              $                    7302009
              
              596
              
              -
              
              5962010
              
              596
              
              -
              
              5962011
              
              436
              
              -
              
              4362012
              
              384
              
              -
              
              384Thereafter
              2,235
              
              -
              
              2,235Total
              
              $                5,262
              
              $          (285)
              
              $                 4,977


F-30


Total
rent expense under operating leases for the years ended December 31, 2007, 2006,
and 2005 was approximately $930,000, $856,000, and $1.3 million,
respectively.





The
Company subleased 3520 sq. ft. of space in the Columbia, Maryland facility which
sublease terminated in October 2005.  For the year ended December 31,
2005, such sublease rentals amounted to $71,000.





On
February 27, 2008, the Company entered into a ten year “Agreement of Lease” to
lease approximately 32,000 square feet of office space located in Eldersburg,
Maryland.  The Company will relocate its corporate headquarters to the
Eldersburg office in July 2008 in conjunction with the expiration of the lease
for its Baltimore facility.  Payment of rent for the Eldersburg office
commences August 1, 2008, and the Company’s future minimum lease payments under
the new lease are reflected in the schedule above.





In
October 2005, the Company signed an “Assignment of Lease and Amendment to Lease”
that assigned and transferred to another tenant (the “assignee”) the Company’s
rights, title and interest in its Columbia, Maryland facility
lease.  The assignee’s obligation to pay rent under the Lease began on
February 1, 2006.  The Company remains fully liable for the payment of
all rent and for the performance of all obligations under the lease through the
scheduled expiration of the lease, May 31, 2008, should the assignee default on
their obligations.  At December 31, 2007, the remaining rental
payments under the lease totaled approximately $285,000.  The Company
relocated its Maryland operations from its Columbia facility to its Baltimore
facility in October 2005.




Letters of credit and performance
bonds







As of
December 31, 2007, the Company was contingently liable for approximately $2.9
million under six letters of credit used as performance bonds on contracts,
which were secured by a cash deposit classified as restricted cash in the
consolidated balance sheet.





Contingencies





Various
actions and proceedings are presently pending to which the Company is a party.
In the opinion of management, the aggregate liabilities, if any, arising from
such actions are not expected to have a material adverse effect on the financial
position, results of operations or cash flows of the Company.







14. Related party
transactions





Prior to
the spin-off discussed in Note 1, Business and basis of presentation, GP
Strategies owned 57% of the Company.





On
January 1, 2005, the Company entered into a Management Services Agreement with
GP Strategies Corporation in which GP Strategies agreed to provide corporate
support services to GSE, including accounting, finance, human resources, legal,
network support and tax.  GSE was charged $685,000 for GP Strategies’
services in 2006, and 2005.   The agreement terminated
on December 31, 2006.


F-31





15.  Employee
benefits





The
Company has a qualified defined contribution plan that covers substantially all
U.S. employees under Section 401(k) of the Internal Revenue Code. Under this
plan, the Company's stipulated basic contribution matches a portion of the
participants' contributions based upon a defined schedule. The Company's
contributions to the plan were approximately
$136,000,  $124,000,  and $93,000 for the years ended
December 31, 2007, 2006, and 2005, respectively.








16.  Segment
information





The
Company has one reportable business segment that provides simulation solutions
and services to the nuclear and fossil fuel power industry, and to the chemical
and petrochemical industries.  Contracts typically range from 10
months to three years.








For the
years ended December 31, 2007, 2006, and 2005, 45%, 60%, and 83% of the
Company’s consolidated revenue was from customers in the nuclear power industry,
respectively. The Company designs, develops and delivers business and technology
solutions to the energy industry worldwide.  Revenue, operating income
(loss) and total assets for the Company’s United States, European, and Asian
subsidiaries as of and for the years ended December 31, 2007, 2006, and 2005 are
as follows:





F-32


(in
      thousands)
              
              Year
      ended December 31, 2007United
      States
              
              Europe
              
              
              Asia
              
              
              Eliminations
              
              ConsolidatedContract
      revenue
              
              $
              28,530
              
              
              $
              3,370
              
              
              $
              -
              
              
              $
              -
              
              
              $
              31,900Transfers
      between geographic locations
              
              
              268
              
              
              
              89
              
              
              
              180
              
              
              
              (537
              )
              
              
              -Total
      contract revenue
              
              $
              28,798
              
              
              $
              3,459
              
              
              $
              180
              
              
              $
              (537
              )
              
              $
              31,900Operating
      income (loss)
              
              $
              2,453
              
              
              $
              (182
              )
              
              $
              (60
              )
              
              $
              -
              
              
              $
              2,211Total
      assets, at December 31
              
              $
              48,251
              
              
              $
              2,061
              
              
              $
              86
              
              
              $
              (22,034
              )
              
              $
              28,364(in
      thousands)
              
              Year
      ended December 31, 2006United
      States
              
              Europe
              
              
              Asia
              
              
              Eliminations
              
              ConsolidatedContract
      revenue
              
              $
              23,975
              
              
              $
              3,527
              
              
              $
              -
              
              
              $
              -
              
              
              $
              27,502Transfers
      between geographic locations
              
              
              329
              
              
              
              70
              
              
              
              166
              
              
              
              (565
              )
              
              
              -Total
      contract revenue
              
              $
              24,304
              
              
              $
              3,597
              
              
              $
              166
              
              
              $
              (565
              )
              
              $
              27,502Operating
      income (loss)
              
              $
              1,928
              
              
              $
              184
              
              
              $
              (12
              )
              
              $
              -
              
              
              $
              2,100Total
      assets, at December 31
              
              $
              37,827
              
              
              $
              2,583
              
              
              $
              80
              
              
              $
              (22,042
              )
              
              $
              18,448Year
      ended December 31, 2005United
      States
              
              Europe
              
              
              Asia
              
              
              Eliminations
              
              ConsolidatedContract
      revenue
              
              $
              19,045
              
              
              $
              2,899
              
              
              $
              6
              
              
              $
              -
              
              
              $
              21,950Transfers
      between geographic locations
              
              
              34
              
              
              
              57
              
              
              
              56
              
              
              
              (147
              )
              
              
              -Total
      contract revenue
              
              $
              19,079
              
              
              $
              2,956
              
              
              $
              62
              
              
              $
              (147
              )
              
              $
              21,950Operating
      loss
              
              $
              (3,995
              )
              
              $
              (647
              )
              
              $
              (85
              )
              
              $
              -
              
              
              $
              (4,727
              )Total
      assets, at December 31
              
              $
              37,803
              
              
              $
              2,282
              
              
              $
              31
              
              
              $
              (28,134
              )
              
              $
              11,982


Approximately
71%, 74%, and 63% of the Company’s 2007, 2006 and 2005 revenue, respectively,
was derived from international sales of its products and services from all of
its subsidiaries.








17.  Supplemental
disclosure of cash flow information





(in
      thousands)
              
              
              Year
      ended December 31,2007
              
              2006
              
              2005Cash
      paid:Interest
              
              
              $                252
              
              $              312
              
              $         156Income
      taxes
              
              $                172
              
              $              194
              
              $         157










F-33


18.  Quarterly financial
data (unaudited)




The
Company’s quarterly financial information has not been audited but, in
management’s opinion, includes all adjustments necessary for a fair
presentation.




(in thousands, except per
      share data)
              
              Year
      ended December 31, 2007 Quarterly DataFirst
              
              
              Second
              
              
              Third
              
              
              FourthQuarter
              
              
              Quarter
              
              
              Quarter
              
              
              QuarterContract
      revenue
              
              $
              7,845
              
              
              $
              8,398
              
              
              $
              7,526
              
              
              $
              8,131Operating
      income
              
              
              452
              
              
              
              733
              
              
              
              504
              
              
              
              522Net
      income
              
              
              31
              
              
              
              348
              
              
              
              303
              
              
              
              487Basic
      income per common share:
              
              $
              -
              
              
              $
              0.03
              
              
              $
              0.02
              
              
              $
              0.03Diluted
      income per common share:
              
              $
              -
              
              
              $
              0.02
              
              
              $
              0.02
              
              
              $
              0.03(in thousands, except per
      share data)
              
              Year
      ended December 31, 2006 Quarterly DataFirst
              
              
              Second
              
              
              Third
              
              
              FourthQuarter
              
              
              Quarter
              
              
              Quarter
              
              
              QuarterContract
      revenue
              
              $
              5,584
              
              
              $
              6,556
              
              
              $
              7,292
              
              
              $
              8,070Operating
      loss
              
              
              212
              
              
              
              439
              
              
              
              686
              
              
              
              763Net
      income (loss)
              
              
              (1,322
              )
              
              
              124
              
              
              
              422
              
              
              
              430Basic
      income (loss) per common share:
              
              $
              (0.12
              )
              
              $
              -
              
              
              $
              0.04
              
              
              $
              0.03Diluted
      income (loss) per common share:
              
              $
              (0.12
              )
              
              $
              -
              
              
              $
              0.03
              
              
              $
              0.03


F-34






ITEM
9. CHANGES IN AND DISAGREEMENTS
WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.









None.








ITEM 9A.CONTROLS AND
PROCEDURES.




(a) Evaluation of Disclosure Controls
and Procedures





The
Company maintains disclosure controls and procedures that are designed to ensure
that information required to be disclosed by it in its reports filed or
submitted pursuant to the Securities Exchange Act of 1934, as amended (the
“Exchange Act”), is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission’s rules and forms
and that information required to be disclosed by the Company in its Exchange Act
reports is accumulated and communicated to management, including the Company’s
Chief Executive Officer (“CEO”), who is its principal executive officer, and
Chief Financial Officer (“CFO”), who is its principal financial officer, to
allow timely decisions regarding required disclosure.





At the end of the period covered by
this report, an evaluation was performed under the supervision and with the
participation of our management including our CEO and our CFO, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13-15(e) of the Exchange Act.  Based on
that evaluation, our chief Executive Officer and Chief Financial Officer
concluded that our disclosure controls and procedures as of December 31, 2007
were effective.





(b)  Management’s Annual
Report on Internal Control over Financial Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Exchange Act rule
13a-15(f).  Our internal control processes and procedures are designed
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of our consolidated financial statements in accordance with
United States generally accepted accounting principles.  Our internal
control over financial reporting includes those policies and procedures that
reasonably allow us to record, process, summarize, and report information and
financial data within prescribed time periods and in accordance with Rule
13-15(e) of the Exchange Act.





Under the
supervision and with the participation of management, including our CEO and CFO,
we conducted an evaluation of internal control over financial reporting as of
December 31, 2007 based on the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission in Internal Control—Integrated
Framework.Based upon our evaluation, we concluded that our
internal control over financial reporting was effective as of December 31,
2007.


The
effectiveness of our internal control over financial reporting as of December
31, 2007 has been audited by KPMG LLP, an independent registered public
accounting firm, whose report appears in Item 8.





(c)  Changes in Internal
Control over Financial Reporting





The
Company has made no significant changes in its internal controls over financial
reporting during the quarter ended December 31, 2007 that have materially
affected or are reasonably likely to materially affect our internal control over
financial reporting.


51





(d)  Limitation of
Effectiveness of Controls





It should
be noted that any system of controls, however well designed and operated, can
provide only reasonable, and not absolute, assurance that the objectives of the
system will be met.  The design of any control system is based, in
part, upon the benefits of the control system relative to its
costs.  Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the Company have been
detected.  These inherent limitations include the realities that
judgments in decision making can be faulty, and that controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people or by management override of control.  In addition, over time,
controls may become inadequate because of changes in conditions, or the degree
of compliance with the policies or procedures may deteriorate.  In
addition, the design of any control system is based in part upon certain
assumptions about the likelihood of future events.  Because of
inherent limitation in a cost-effective control system, misstatements due to
error or fraud may occur and not be detected.  The Company’s controls
and procedures are designed to provide a reasonable level of assurance of
achieving their objectives.








ITEM 9B.  OTHER
INFORMATION.





None.








PART III





ITEM 10.DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.




The
information required by this item, including items 401, 405 406 and 407 of
Regulation S-K, is incorporated by reference to the sections captioned “Directors and Executive
Officers” and “Section
16(A) Beneficial Ownership Reporting Compliance” in the definitive Proxy
Statement for the Company’s 2008 Annual Meeting of Shareholders and incorporated
herein by reference or will be provided in an amendment to this Annual Report on
Form 10-K.







The
Company has adopted a Code of Business Ethics and Policy that applies to its
directors, officers and employees, including its principal executive officer,
and principal financial officer.  The code of Business Ethics and
Policy is available on our website at www.gses.com.  The
Company will post on its website information about any amendment to, or waiver
from, any provision of the Code of Business Ethics and Policy that applies to
its principal executive officer, principal financial officer, or principal
accounting officer.








ITEM 11.EXECUTIVE
COMPENSATION.





The
information required by this item will either be set forth under the “Compensation of Directors and
Executive Officers” section in the definitive Proxy Statement for the
2008 Annual Meeting of Shareholders and incorporated herein by reference or will
be provided in an amendment to this Annual Report on Form 10-K.


52





ITEM 12.SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS.




The
information required by this item will be either set forth under the sections
captioned “Voting Securities
and Principal Holders Thereof,”and “Compensation of Directors and
Executive Officers” in the definitive Proxy Statement for the 2008 Annual
Meeting of Shareholders and incorporated herein by reference or will be provided
in an amendment to this Annual Report on Form 10-K.










ITEM 13.CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE.




The
information required by this item will be either set forth under the “Directors and Executive
Officers" section in the definitive Proxy Statement for the 2008 Annual
Meeting of Shareholders and incorporated herein by reference or will be provided
in an amendment to this Annual Report on Form 10-K.







ITEM 14.PRINCIPAL
ACCOUNTING FEES AND SERVICES.




The
information required by this item will be either set forth under the “Directors and Officers”section in the definitive Proxy Statement for the 2008 Annual Meeting of
Shareholders and incorporated herein by reference or will be provided in an
amendment to this Annual Report on Form 10-K.




53




PART IV







ITEM 15.
            EXHIBITS AND FINANCIAL
      STATEMENT SCHEDULES








(a)
(1)  List of Financial Statements





The
following financial statements are included in Item 8:


GSE Systems, Inc. and
      SubsidiariesReport
      of Independent Registered Public Accounting Firm – Internal Control over
      Financial ReportingReport
      of Independent Registered Public Accounting Firm – Consolidated Financial
      StatementsConsolidated
      Balance Sheets as of December 31, 2007 and 2006Consolidated
      Statements of Operations for the years ended December 31, 2007, 2006, and
      2005Consolidated
      Statements of Comprehensive Income (Loss) for the years ended December 31,
      2007,
              2006,  and
      2005Consolidated
      Statements of Changes in Stockholders' Equity for the years ended December
      31, 2007,
              2006,
      and 2005Consolidated
      Statements of Cash Flows for the years ended December 31, 2007, 2006, and
      2005Notes
      to Consolidated Financial
Statements





(a)
(2)  List of Schedules





All other
schedules to the consolidated financial statements are omitted as the required
information is either inapplicable or presented in the consolidated financial
statements or related notes.








(a)
(3)  List of Exhibits





The
Exhibits which are filed with this report or which are incorporated by reference
are set forth in the Exhibit Index hereto.









54


SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) 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.





GSE Systems, Inc.





By:         /s/JOHN
MORAN


John Moran


Chief
Executive Officer







Pursuant
to the requirements of the Securities Act, this report has been signed by the
following persons in the capacities and on the dates indicated.




Date:  March
17,
2008                                                                           /s/JOHN
MORAN


John
Moran, Chief Executive Officer


(Principal Executive
Officer)





Date:
March 17,
2008                                                                           /s/ JEFFERY G.
HOUGH


Jeffery G. Hough, Senior Vice
President


and Chief Financial
Officer


(Principal
Financial and Accounting Officer)








Date:
March 17,
2008           (Jerome I.
Feldman, Chairman of the Board)       By:  /s/ JEFFERY G.
HOUGH


(Michael D. Feldman,
Director                     )              Jeffery
G. Hough


(Dr. Sheldon L. Glashow,
Director               )        Attorney-in-Fact


(Scott N. Greenberg,
Director                       )


(Dr. Roger Hagengruber,
Director               )


(Joseph W. Lewis,
Director                          )


(George J. Pedersen,
Director                      
)


(Orrie Lee Tawes III,
Director                      
)





A Power
of Attorney, dated February 13, 2008 authorizing Jeffery G. Hough to sign this
Annual Report on Form 10-K for the fiscal year ended December 31, 2007 on behalf
of certain of the directors of the Registrant is filed as Exhibit 24.1 to this
Annual Report.




55





Exhibit
            Description of
      Exhibit3
            Articles of Incorporation and
      Bylaws3(i)
            Fourth
      Amended and Restated Certificate of Incorporation of the
      Company.   Previously filed in connection with the GSE
      Systems, Inc. Form DEF 14A as filed with the Securities and Exchange
      Commission on November 20, 2007 and incorporated herein by
      reference.3(ii)
            Amended
      and Restated Bylaws of the Company.  Previously filed in
      connection with Form DEF 4A as filed with the Securities and Exchange
      Commission on November 20, 2007 and incorporated herein by
      reference.4.
            Instruments Defining Rights of
      Security Holders, including Indenture.4.1
            Specimen
      Common Stock Certificate of the Company. Previously filed in connection
      with Amendment No. 3 to the GSE Systems, Inc. Form S-1 Registration
      Statement as filed with the Securities and Exchange Commission on July 24,
      1995 and incorporated herein by reference.4.2
            Preferred
      Stock Issuance Agreement by and between GSE Systems, Inc. and ManTech
      International Corporation (dated December 5, 2001).  Previously
      filed in connection with the GSE Systems, Inc. Form 8-K as filed with the
      Securities and Exchange Commission on December 12, 2001 and incorporated
      herein by reference.4.3
            Cancellation
      and Warrant Exchange Agreement dated February 28, 2006 by and among GSE
      Systems, Inc. and Dolphin Direct Equity Partners,
      LP.  Previously filed in connection with the GSE Systems, Inc.
      Form 8-K filed with the Securities and Exchange Commission on March 6,
      2006 and incorporated herein by reference.4.4
            Registration
      Rights Agreement dated February 28, 2006 by and among GSE Systems, Inc.
      and Dolphin Direct Equity Partners, LP.  Previously filed in
      connection with the GSE Systems, Inc. Form 8-K filed with the Securities
      and Exchange Commission on March 6, 2006 and incorporated herein by
      reference.





56


Exhibit
            Description of
      Exhibit4.5
            Senior
      Subordinated Secured Convertible Note and Warrant Purchase Agreement dated
      as of May 26, 2005 by and among GSE Systems, Inc. and Dolphin Direct
      Equity Partners, LP.  Previously filed in connection with the
      GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 6, 2006 and incorporated herein by
      reference.4.6
            Form
      of Senior Subordinated Secured Convertible Promissory Note dated as of May
      26, 2005 issued by and among GSE Systems, Inc. and Dolphin Direct Equity
      Partners, LP in the aggregate principal amount of $2,000,000. Previously
      filed in connection with the GSE Systems, Inc. Form 8-K filed with the
      Securities and Exchange Commission on March 6, 2006 and incorporated
      herein by reference.4.7
            Form
      of Warrant to Purchase 900,000 shares of Common Stock of GSE Systems, Inc.
      dated as of February 28, 2006.  Previously filed in connection
      with the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 6, 2006 and incorporated herein by
      reference.4.8
            Form
      of Warrant to Purchase 380,952 shares of Common Stock of GSE Systems, Inc.
      dated as of May 26, 2005.  Previously filed in connection with
      the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 6, 2006 and incorporated herein by
      reference.4.9
            Form
      of Warrant to Purchase 150,000 shares of Common Stock of GSE Systems, Inc.
      dated as of February 28, 2006.  Previously filed in connection
      with the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 6, 2006 and incorporated herein by
      reference.4.10
            Certificate
      of Designation, Preferences and Rights of Series A Cumulative Preferred
      Stock dated as of February 28, 2006 providing for the issuance of a series
      of 42,500 shares of Series A Cumulative Convertible Preferred Stock, par
      value $0.01 per share.  Previously filed in connection with the
      GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 6, 2006 and incorporated herein by
      reference.4.11
            Form
      of Warrant to Purchase 367,647 shares of the Company’s Common Stock dated
      as of March 7, 2006.  Previously filed in connection with the
      GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 13, 2006 and incorporated herein by
      reference.





57


Exhibit
            Description of
      Exhibit4.12
            Grant
      of Security Interest in Patents and Trademarks by and among GSE Systems,
      GSE Power Systems, Inc. and Laurus Master Fund, Ltd. dated March 7,
      2006.  Previously filed in connection with the GSE Systems, Inc.
      Form 8-K filed with the Securities and Exchange Commission on March 13,
      2006 and incorporated herein by reference.4.13
            Subsidiary
      Guaranty by and among GSE Services Company LLC, MSHI, Inc., GSE
      Power Systems, Inc., GSE Erudite Software Inc., GSE Government &
      Military Simulation Systems, Inc., and GSE Process Solutions, Inc. and
      Laurus Master Fund, Ltd. dated as of March 7, 2006.  Previously
      filed in connection with the GSE Systems, Inc. Form 8-K filed with the
      Securities and Exchange Commission on March 13, 2006 and incorporated
      herein by reference.4.14
            Control
      Agreement by and among GSE Systems, Inc., Laurus Master Fund Ltd. and GSE
      Services Company LLC dated as of March 7, 2006.  Previously
      filed in connection with the GSE Systems, Inc. Form 8-K filed with the
      Securities and Exchange Commission on March 13, 2006 and incorporated
      herein by reference.4.15
            Security
      Agreement by and among GSE Systems, Inc., GSE Power Systems,
      Inc.  and Laurus Master Fund, Ltd. dated as of March 7,
      2006.  Previously filed in connection with the GSE Systems, Inc.
      Form 8-K filed with the Securities and Exchange Commission on March 13,
      2006 and incorporated herein by reference.4.16
            Registration
      Rights Agreement by and among GSE Systems, Inc. and Laurus Master Fund,
      Ltd. dated as of March 7, 2006.  Previously filed in connection
      with the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on March 13, 2006 and incorporated herein by
      reference.4.17
            Stock
      Pledge Agreement by and among the Company, MSHI, Inc., GSE Power Systems,
      Inc., GSE Process Solutions, Inc. and Laurus Master Fund, Ltd. dated as of
      March 7, 2006.  Previously filed in connection with the GSE
      Systems, Inc. Form 8-K filed with the Securities and Exchange Commission
      on March 13, 2006 and incorporated herein by reference.4.18
            Secured
      Non-Convertible Revolving Note dated as of March 7,
      2006.  Previously filed in connection with the GSE Systems, Inc.
      Form 8-K filed with the Securities and Exchange Commission on March 13,
      2006 and incorporated herein by reference.





58


Exhibit
            Description of
      Exhibit4.19
            Securities
      Purchase Agreement, dated as of June 15, 2007 by and between GSE Systems,
      Inc. and each of the Investors to sell a total of 1,666,667 shares of GSE
      Common Stock.  Previously filed in connection with the GSE
      Systems, Inc. Form 8-K filed with the Securities and Exchange Commission
      on June 18, 2007 and incorporated herein by reference.4.20
            Form
      of Warrant issued by GSE Systems, Inc to each of the Investors to purchase
      shares of GSE Common Stock.  Previously filed in connection with
      the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on June 18, 2007 and incorporated herein by
      reference.4.21
            Registration
      Rights Agreement, dated as of June 15, 2007 by and between GSE Systems,
      Inc. and each of the Investors.  Previously filed in connection
      with the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on June 18, 2007 and incorporated herein by
      reference.4.22
            Consent
      and Waiver, dated as of June 15, 2007, among GSE Systems, Inc., GSE Power
      Systems, Inc. and Laurus Master Fund Ltd. Previously filed in connection
      with the GSE Systems, Inc. Form 8-K filed with the Securities and Exchange
      Commission on June 18, 2007 and incorporated herein by
      reference.10.
            Material
      Contracts10.1
            Agreement
      among ManTech International Corporation, National Patent Development
      Corporation, GPS Technologies, Inc., General Physics Corporation,
      Vattenfall Engineering AB and GSE Systems, Inc. (dated as of April 13,
      1994). Previously filed in connection with the GSE Systems, Inc. Form S-1
      Registration Statement as filed with the Securities and Exchange
      Commission on April 24, 1995 and incorporated herein by
      reference.10.2
            GSE
      Systems, Inc. 1995 Long-Term Incentive Plan, amended as of September 25,
      2007. Previously filed in connection with the GSE Systems, Inc. Form DEF
      14A as filed with the Securities and Exchange Commission on November 20,
      2007 and incorporated herein by reference. *10.3
            Form
      of Option Agreement Under the GSE Systems, Inc. 1995 Long-Term Incentive
      Plan.  Previously filed in connection with the GSE Systems, Inc.
      Form 10-K as filed with the Securities and Exchange Commission on March
      22, 1996 and incorporated herein by reference.
*





59


Exhibit
            Description
      of Exhibit10.4
            Office
      Lease Agreement between Sterling Rutherford Plaza, LLC and GSE Systems,
      Inc. (dated as of February 10, 1998). Previously filed in connection with
      the GSE Systems, Inc. Form 10-K as filed with the Securities and Exchange
      Commission on March 21, 1998 and incorporated herein by
      reference.10.5
            Office
      Lease Agreement between Red Branch Road, LLC and GSE Systems, Inc. (dated
      February 10, 1998). Previously filed in connection with the GSE Systems,
      Inc. Form 10-K as filed with the Securities and Exchange Commission on
      March 21, 1998 and incorporated herein by reference.10.6
            Assignment
      of Lease and Amendment of Lease between GSEM, LLC and GSE Systems,
      Inc.  Previously filed in connection with the GSE Systems, Inc.
      Form 10-K as filed with the Securities and Exchange Commission on March
      31, 2006 and incorporated herein by reference.10.7
            Office
      Lease Agreement between 1332 Londontown, LLC and GSE Systems, Inc. (dated
      as of February 27, 2008).   Previously filed in connection
      with the GSE Systems, Inc. Form 8-K as filed with the Securities and
      Exchange Commission on March 11, 2008 and incorporated herein by
      reference.10.8
            Management
      Services Agreement between GSE Systems, Inc. and GP Strategies Corporation
      dated January 1, 2004. Previously filed in connection with the GSE
      Systems, Inc. Form 10-K filed with the Securities and Exchange Commission
      on April 14, 2004 and incorporated herein by reference.10.9
            Memorandum
      of Association of Limited Liability Company dated November 8, 2005 by and
      between Al Qudra Holding PJSC, Centre of Excellence for Applied Research
      and Training, and GSE Systems, Inc.  Previously filed in
      connection with the GSE Systems, Inc. Form 10-Q/A filed with the
      Securities and Exchange Commission on October 4, 2006 and incorporated
      herein by reference.10.10
            Supply
      Agreement Contract by and between Emirates Simulation Academy, LLC and GSE
      Power Systems, Inc. dated January 3, 2006.  Previously filed in
      connection with the GSE Systems, Inc. Form 10-Q/A filed with the
      Securities and Exchange Commission on October 4, 2006 and incorporated
      herein by reference.





60


Exhibit
            Description
      of Exhibit10.11
            License
      and Technology Transfer Agreement by and Between GSE Power Systems, Inc.
      and Emirates Simulation Academy, LLC dated January 3,
      2006.  Previously filed in connection with the GSE Systems, Inc.
      Form 10-Q/A filed with the Securities and Exchange Commission on October
      4, 2006 and incorporated herein by
reference.





14.
            Code of
      Ethics14.1
            Code
      of Ethics for the Principal Executive Officer and Senior Financial
      Officers.  Previously filed in connection with the GSE Systems,
      Inc. Form 10-K file with the Securities and Exchange Commission on March
      31, 2006 and incorporated herein by reference.21.
            Subsidiaries.21.1
            List
      of Subsidiaries of Registrant at December 31, 2007, filed
      herewith.23.
            Consents of Experts and
      Counsel23.1.
            Consent
      of KPMG LLP, filed herewith.24.
            Power of
      Attorney24.1
            Power
      of Attorney for Directors’ and Officers’ Signatures on SEC Form 10-K,
      filed herewith.31.
            Certifications31.1
            Certification
      of Chief Executive Officer of the Company pursuant to Securities and
      Exchange Act Rule 13d-14(a)/15(d-14(a), as adopted pursuant to Section 302
      and 404 of the Sarbanes-Oxley Act of 2002, filed
  herewith.31.2
            Certification
      of Chief Financial Officer of the Company pursuant to Securities and
      Exchange Act Rule 13d-14(a)/15(d-14(a), as adopted pursuant to Section 302
      and 404 of the Sarbanes-Oxley Act of 2002, filed herewith.32.
            Section 1350
      Certifications32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer of the Company
      pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002, file herewith.*   Management
      contracts or compensatory plans required to be filed as exhibits pursuant
      to Item 14 (c) of this report.