**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

**(Mark One)**

**x**                               ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the fiscal year ended December 31, 2005**

**OR**

**o**                                  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition period from                 to **

**Commission file number 0-23655**

**INTERNETSECURITY SYSTEMS, INC.**

(Exactname of Registrant as Specified in Its Charter)

| **Delaware**                             |   | **58-2362189**      |
|------------------------------------------|--------|---------------------|
| (State or other jurisdiction of          |   | (I.R.S. Employer    |
| incorporation or organization)           |   | Identification No.) |
| **6303 Barfield Road**                   |   |                |
| **Atlanta, Georgia**                     |   | **30328**           |
| (Address of principal executive offices) |   | (Zip code)          |

 

Registrant’stelephone number, including area code:** (404) 236-2600**

Securitiesregistered pursuant to Section 12(b) of the Act: **None**

Securities registeredpursuant to Section 12(g) of the Act:

**Common Stock, $0.001 par valuePreferred Stock Purchase Rights(Title of Class)**

Indicateby a check mark if the registrant is a well-known seasoned issuer, as definedin Rule 405 of the Securities Act. Yes   x   No   o

Indicateby a check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act. Yes   o   No   x

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes   x   No   o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.   x

Indicateby a check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

Large accelerated filer   x            Acceleratedfiler   o            Non-acceleratedfiler   o

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes   o   No   x

Theaggregate market value of the voting stock held by non-affiliates of theRegistrant, based upon the closing sale price of Common Stock on June 30,2005 as reported on the Nasdaq National Market, was approximately $704 million(affiliates being, for these purposes only, directors, executive officers andholders of more than 5% of the Registrant’s Common Stock).

Asof February 23, 2006 the Registrant had 44,763,166 outstanding shares ofCommon Stock.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portions of the Proxy Statement for the Registrant’sAnnual Meeting of Stockholders to be held on May 26, 2006 are incorporatedby reference into Part III of this Form 10-K.

 

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**TABLE OF CONTENTS**
| PART I                                              |   |                                                                                                                   | ** ** | ** ** |
|----------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------|------------|------------|
| Item 1.                                                  |   | Business                                                                                                               |       | 3          |
| Item 1A.                                                 |   | Risk Factors                                                                                                           |       | 8          |
| Item 1B.                                                 |   | Unresolved  Staff Comments                                                                                             |       | 16         |
| Item 2.                                                  |   | Properties                                                                                                             |       | 16         |
| Item 3.                                                  |   | Legal  Proceedings                                                                                                     |       | 16         |
| Item 4.                                                  |   | Submission  of Matters to a Vote of Security Holders                                                                   |       | 17         |
| PART II                                             |   |                                                                                                                   |       |       |
| Item 5.                                                  |   | Market  for Registrant’s Common Equity and Related Stockholder Matters and Issuer  Purchases of Equity Securities |       | 18         |
| Item 6.                                                  |   | Selected  Financial Data                                                                                               |       | 20         |
| Item 7.                                                  |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            |       | 21         |
| Item 7A.                                                 |   | Quantitative and  Qualitative Disclosures About Market Risk                                                            |       | 32         |
| Item 8.                                                  |   | Consolidated  Financial Statements and Supplementary Data                                                              |       | 34         |
| Item 9.                                                  |   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                                  |       | 35         |
| Item 9A.                                                 |   | Controls  and Procedures                                                                                               |       | 35         |
| Item 9B.                                                 |   | Other  Information                                                                                                     |       | 37         |
| PART III                                            |   |                                                                                                                   |       |       |
| Item 10.                                                 |   | Directors  and Executive Officers of the Registrant                                                                    |       | 37         |
| Item 11.                                                 |   | Executive  Compensation                                                                                                |       | 37         |
| Item 12.                                                 |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                       |       | 37         |
| Item 13.                                                 |   | Certain  Relationships and Related Transactions                                                                        |       | 37         |
| Item 14.                                                 |   | Principal  Accountant Fees and Services                                                                                |       | 37         |
| PART IV                                             |   |                                                                                                                   |       |       |
| Item 15.                                                 |   | Exhibits  and Financial Statement Schedules                                                                            |       | 38         |
| REPORT  OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM |   | 40                                                                                                                     |
| SCHEDULE II                                              |   | 64                                                                                                                     |
| EX-21.1 SUBSIDIARIES OF THE COMPANY                      |   |                                                                                                                   |
| EX-23.1 CONSENT OF ERNST & YOUNG LLP            |   |                                                                                                                   |
| EX-31.1 SECTION 302 CERTIFICATION OF THE  CEO       |   |                                                                                                                   |
| EX-31.2 SECTION 302 CERTIFICATION OF THE  CFO       |   |                                                                                                                   |
| EX-32.1 SECTION 906 CERTIFICATION OF THE  CEO       |   |                                                                                                                   |
| EX-32.2 SECTION 906 CERTIFICATION OF THE  CFO       |   |                                                                                                                   |

 

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*In this Form 10-K,the words “Internet Security Systems,” “ISS,” “the Company,” “we,” “our,” “ours,”and “us” refer to Internet Security Systems, Inc., and its subsidiaries.*

*This Annual Reporton Form 10-K contains forward-looking statements. Forward-lookingstatements can be identified by the use of words such as “may,” “will,” “should,”“could,” “continue,” “future,” “potential,” “believe,” “project,” “plan,” “intend,”“seek,” “estimate,” “predict”, “expect”, “anticipate” and similar expressions,or the negative of such terms, or other comparable terminology. Forward-lookingstatements also include the assumptions underlying or relating to any of theforegoing statements. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including those set forth below under the caption “Risk Factors” and thoseotherwise described from time to time in our Securities and Exchange Commissionreports filed after this Form 10-K. All forward-looking statementsincluded in this Form 10-K are based on information available to ISSon the date hereof. We assume no obligation (except where required by law) toupdate any forward-looking statements for any events or circumstances occurringafter the date of this Form 10-K.*

*Internet Security Systems, Network ICE, SystemScanner, Wireless Scanner, SiteProtector, SecurePartner and X-Press Update aretrademarks and service marks, BlackICE is a licensed trademark and the InternetSecurity Systems logo, X-Force, Proventia, RealSecure, Internet Scanner, andDatabase Scanner are registered trademarks and service marks, of InternetSecurity Systems, Inc. Each trademark, trade name or service mark of anyother company appearing herein belongs to its holder.*

**PART I**

**Item 1.**                        *Business*

**Introduction**

Internet Security Systems, Inc. is a trustedsecurity expert to global enterprises and world governments, providingsoftware, appliances and services that protect IT infrastructure againstInternet threats. An established world leader in security since 1994, ISSdelivers proven cost efficiencies and reduces regulatory and business riskacross the enterprise for customers worldwide. ISS products and services arebased on the proactive security intelligence conducted by its research anddevelopment team. With headquarters in Atlanta, ISS operates throughout theAmericas, Asia, Australia, Europe and the Middle East. ISS is publicly tradedon the Nasdaq (ISSX).

The mailing address forour headquarters is 6303 Barfield Road, Atlanta, Georgia, 30328, and ourtelephone number at that location is (404) 236-2600. Our website canbe found at www.iss.net. We make available free of charge through our websiteour Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q,and Current Reports on Form 8-K, and amendments to those reports, assoon as reasonably practicable after we file them electronically with, orfurnish them to, the Securities and Exchange Commission. Our CorporateGovernance Guidelines and Code of Conduct are also available on our website andare available in print to any stockholder who mails a request to ourheadquarters, attention to the Corporate Secretary. Our website also containsother corporate governance-related documents that may be of interest tostockholders. The information on our website is not part of this Form 10-K.

**Acquisitions**

We use strategic acquisitions and partnerships asnecessary to provide certain technology, people and products for our overallproduct and services strategy. We consider both time to market and potentialmarket share growth when evaluating partnerships, acquisitions of technologies,product lines or companies.

We believe that our total solutions approach willpositively impact all of our revenue categories. This includes our products andmanaged services offerings, as well as product support, professional servicesand 

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training. While we expectthe expansion of these product and service offerings to originate primarilyfrom internal development, our strategy includes acquiring products, technologiesand service capabilities that fit within our strategy and could potentiallyaccelerate the timing of the commercial introduction of such products andtechnologies.

In January 2004, we acquired Cobion AG a providerof content filtering and anti-spam technology that protects individuals andenterprises against unwanted Web content, spam, misuse of information and lostproductivity.

On October 30, 2002, we acquired vCIS, Inc.a development stage company focused on the development of software designed toenhance the security of a computing environment by detecting and defeatingmalicious code, including viruses, worms and Trojans, in real-time usingbehavior analysis technology.

On June 5, 2001, weacquired Network ICE Corporation (Network ICE), a developer of desktopintrusion protection technology and highly scalable security managementsystems.

**Product**

ISS software and appliance products provide preemptivesecurity across all layers of IT infrastructure: network gateways, servers andendpoint devices like PCs, laptops and handhelds. Our products incorporate avariety of security technologies, including intrusion prevention systems (IPS),intrusion detection systems (IDS), firewall and virtual private networking(VPN), content security, web filtering, antispam, antivirus, vulnerabilityassessment and security management. Our primary product line for enterprisesconsists of Proventia® appliances. We continue to market and sell ourlegacy brand of RealSecure® software solutions. We offer two small office andconsumer products, BlackICETM PC Protection and BlackICE Server Protectionsoftware, as well. Below is a more detailed overview of ISS’ product offeringsorganized by security technology.

We use a range of feestructures to license our products, depending on the type of product and theintended use. Fees for our product line can be comprised of two components:1) a platform fee, which includes the hardware and a perpetual or termlicense to the underlying software; and 2) annually renewable software andhardware maintenance, which includes product support and content updates. Avariety of pricing structures are offered to fit different customerenvironments.

*IntrusionPrevention*

ISS offers Proventiaintrusion prevention appliances and software to preemptively protect enterprisenetwork gateways, servers and endpoint devices from malicious attacks. TheProventia intrusion prevention appliances and software are available in avariety of models rated for speed, capacity, and operating system.

*Intrusion Detection*

ISS offers Proventiaintrusion detection appliances for network IDS, forensics and responsetechnology. These appliances come in a range of models with varying speeds andcapacity. ISS continues to maintain its legacy IDS products, RealSecure Network10/100 and RealSecure Network Gigabit software.

*Integrated Security(combines IPS, firewall, VPN, Web filtering, antispam and antivirus)*

ISS offers Proventiaintegrated security appliances to provide robust protection for remote andbranch offices that are simple to deploy and manage. These appliances combineintrusion prevention, firewall, VPN, Web filtering, antispam and antivirus in asingle device and come in a range of models with varying speeds and capacity.

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*VulnerabilityAssessment*

ISS offers InternetScanner® software for comprehensive vulnerabilityassessment across enterprise networks, servers, desktops and wireless networks.In 2006, ISS expects to introduce the new Proventia Scanner appliance forcontinuous comprehensive vulnerability assessment across enterprise networks,servers, desktops and wireless networks.

*Content Security*

ISS offers Proventia MailFilter and Proventia Web Filter for content security. Proventia Mail Filtermonitors the content of e-mail traffic, eliminating spam and blockingundesirable or illegal content. Proventia Web Filter blocks unwanted Webcontent. In 2006, ISS expects to introduce the new Proventia Mail Filterappliance that monitors the content of e-mail traffic, eliminating spam andblocking undesirable or illegal content.

*Security Management*

ISS offers theSiteProtector centralized management system for scalable, centralizedmanagement of all ISS products. SiteProtector significantly reduces demand onstaff and other operational resources. The SiteProtector Security Fusion moduleuses advanced data correlation and analysis to derive the likelihood of asuccessful attack from aggregated vulnerability assessment information. TheSiteProtector Third Party module interfaces with market leading firewalls—suchas Check Point and Cisco PIX—to automate the collection of audit and intrusiondetection events into the SiteProtector system for advanced analysis. TheSiteProtector Reporting Module offers graphical management reportingcapabilities to convey security status.

*Consumer/SmallOffice Products*

We continue to offerBlackICE PC Protection and BlackICE Server protection software for powerful,affordable firewall and intrusion detection for the consumer and small officeproduct market.

**Services and Support**

ISS offers both professional and managed securityservices to help enterprise customers reduce the risk of online attacks. ProfessionalSecurity Services from ISS help enterprises plan and implement a securitystrategy with assessment, design, deployment, management and education services.For organizations lacking the time, expertise or appropriate internal resourcesto effectively secure their corporate networks and online resources, we offerManaged Security Services. Our Managed Security Services provide 24 ́7monitoring and management, advanced correlation, event prioritization and rapidincident response upon detection.

Managed security services fees are determined by thecomplexity of the monitoring arrangement and by the number of devices beingmonitored. These fees are typically billed monthly as services are performed. Ourprofessional services fees are calculated either on a fixed-fee basis or anhourly rate per consultant based on the scope of the engagement, market sectorand geographical territory. Educational services are calculated on a per-classbasis.

ISS offers technicalsupport to customers worldwide. Our standard annual maintenance contractprovides 24 ́7 telephonetechnical support, 24 ́7 online supportincident submission and tracking, product updates and enhancements, access tothe True Blue Customer Portal, online incident submission and tracking,priority notification of new and emerging security threats, and unlimitedaccess to the ISS Knowledgebase and X-Force Threat and Vulnerability Database. NorthAmerica customers may upgrade 

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theirstandard support contracts to select support or premium support for betterresponse times, access to senior technical support, and other services. Maintenanceagreements are generally renewable annually.

**Sales, Marketing and Customers**

As of the end of fiscal 2005, our worldwide sales andmarketing organization consisted of 390 individuals, including managers, salesrepresentatives, and sales support personnel. We have field sales offices in 22countries and sell our products and services both directly and through avariety of channels with support from our sales force. A substantial portion ofour products and services are sold through our channel partners and theremainder are sold through direct sales. Our channel partners include systemintegrators, service providers, other resellers, distributors, and retailpartners. During 2005, channel sales accounted for 75% of product licensessold.

System integrators and service providers typicallysell directly to end users and often provide system installation, technicalsupport, professional services, and other support services in addition tosecurity product sales. System integrators also typically integrate ourproducts into an overall solution. Distributors operate in a two-tier systemtypically selling to system integrators, service providers, and other resellerswho sell to the end customer. Revenue from the channel is recognized based onthe sell-through method, meaning that the sale has occurred with the channelfor an identified end user.

Our marketing activities include: market segment andcompetitive analysis, strategic brand and product planning, public relations,industry analyst relations and education; publication of technical andeducational articles in both print and online media (through our white papers,and through our own print and online newsletters and/or magazines); direct mailand email; participation in industry tradeshows; product/technologyconferences, seminars, and web casts; competitive analysis; sales training;advertising and development and distribution of marketing literature; andmaintenance of our Web site.

Oursales organization is divided into three geographic areas: the Americas (UnitedStates, Canada, Latin America and South America), EMEA (Europe, Middle East andAfrica) and Asia/Pacific. These geographic areas represent our three reportablesegments. The accounting policies of the reportable geographic segments are thesame as described under the caption “Critical Accounting Policies” in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andin our consolidated financial statements, and are applied consistently acrossthe segments. Revenues, as a percentage of total revenues, for each segment areas follows:

| ** **   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
| Americas     |       |     | 63         | %        |       |     | 64         | % |   |   | 69 | % |   |
| EMEA         |       |     | 22         |     |       |     | 22         |   |   |   | 19 |   |   |
| Asia/Pacific |       |     | 15         |     |       |     | 14         |   |   |   | 12 |   |   |

 

**X-Force Research**

Our X-Force research organization is a group ofsecurity experts who investigate security flaws in software that could becomethe target of online attacks as well as emerging threats that appear on theInternet. From X-Force research, we develop updates for our products andservices to protect against the latest vulnerabilities and threats. Theseupdates quickly and easily self-install into our software and appliances.X-Force research and analysis is a differentiator for our offerings, which helpkeep our customers ahead of online threats. By researching the actualvulnerabilities, or weak spots in software that become the point of entry fornew attacks, we create protection updates that shield the weak spots, oftenbefore a threat is even developed.

The X-Force organizationoperates out of our Global Threat Operations Center—which is a specializedthreat intelligence facility in Atlanta that collects security trendinformation from our 

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five state-of-the-artSecurity Operations Centers operating on three continents—to analyze the natureand severity of any threat in real-time. The X-Force then helps deliver oursolutions to market via alerts, advisories, product updates, professionalservices, emergency response services and 24 ́7remotely managed security services. In addition, the X-Force produces afee-based X-Force Threat Analysis Service for customers that require immediate,comprehensive notification of security events, threats and vulnerabilities.

**Product Development**

We use a multiple product sourcing strategy thatincludes internal development, licensing from third parties, and acquisitionsof technologies or companies. We have incorporated a modular design in oursoftware products to permit plug-and-play capabilities, although customersoften use our professional services or our strategic partners to install andconfigure products for use in larger or more complex network systems.

We use strategic acquisitions and partnerships asnecessary to provide certain technology, people and products for our overallproduct and services strategy. We consider both time to market and potentialmarket share growth when evaluating partnerships, acquisitions of technologies,product lines or companies.

Expenses for productdevelopment were $45.2 million, $43.0 million and $41.8 million in 2005, 2004and 2003, respectively.

**Competition**

The market for network security monitoring, detection,prevention and response solutions is intensely competitive, and we expectcompetition to increase in the future. We believe that the principalcompetitive factors affecting the market for information security solutionsinclude security effectiveness, manageability, technical features, performance,ease of use, price, scope of product offerings, professional servicescapabilities, distribution relationships and customer service and support. Althoughwe believe that our solutions generally compete favorably with respect to suchfactors, we cannot guarantee that we will compete successfully against currentor potential competitors, especially those with significantly greater financialresources or brand name recognition.

We compete against manycompanies who offer competing products to our technology solutions andcompeting services to our response and support. Some of the companies wecompete against are Symantec Corporation, McAfee, Inc., Check PointSoftware Technologies, LTD, 3Com Corporation, Juniper Networks, and CiscoSystems, Inc. In addition, we compete with large technology companies such asComputer Associates, IBM, and Microsoft that may offer network and systemprotection products as enhancements to their operating systems; we also facecompetition from smaller companies and shareware authors that may developcompeting products.

**Customers**

We provide products and services to a variety of endusers worldwide, including many of the world’s largest banks, IT companies,telecommunications providers, auto manufacturers and insurance providers, aswell as U.S. and other national, state, and local governments. We view ourprimary customers as enterprise, service provider and risk managemententerprises, but we have also developed products and services for the consumerand small office market. Our enterprise market customers generally have annualrevenues exceeding $500 million.

No customer accounted formore than 10% of our consolidated revenues in 2005, 2004 or 2003. Targetcustomers include both public and private sector organizations, as well asconsumers. Business 

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customersrepresent a broad spectrum of organizations within diverse sectors, includingfinancial services, technology, telecommunications, and government andinformation technology services.

**Intellectual Property**

We rely primarily on copyright, trademark, patent andtrade secret laws, confidentiality procedures and contractual provisions toprotect our intellectual property and other proprietary rights. We haveobtained several United States patents, one Taiwanese patent and have a numberof patent applications pending in the United States and certain foreignjurisdictions. We believe that the technological and creative skills of ourpersonnel, new product developments, frequent product enhancements, our namerecognition, our professional services capabilities and delivery of reliableproduct maintenance are essential to establishing and maintaining a technologyleadership position. We cannot assure you that our competitors will not developtechnologies that are similar to ours. We generally license our softwareproducts to end users in object code (machine-readable) format. Some of ourcustomers have required us to maintain a source-code escrow account with athird-party software escrow agent, and a failure by us to perform ourobligations under any of the related license and maintenance agreements, or ourinsolvency, could result in the release of our product source code to suchcustomers. The standard form license agreement for our software products allowsthe end user to use our products solely on the end user’s computer equipmentfor the end user’s internal purposes, and the end user is generally prohibitedfrom sublicensing or transferring the products.

Despite our efforts toprotect our intellectual property, unauthorized parties may attempt to copyaspects of our products or to obtain and use information that we regard asproprietary. Policing unauthorized use of our products is difficult. While wecannot determine the extent to which piracy of our software products occurs, weexpect software piracy to be a persistent problem. In addition, the laws ofsome foreign countries do not protect our proprietary rights to as great anextent as do the laws of the United States and many foreign countries do notenforce these laws as diligently as U.S. government agencies and privateparties. See “Item 1A—Risk Factors.”

**Employees**

As of December 31,2005, we had 1,252 employees, of whom 267 were engaged in product research anddevelopment, 390 were engaged in sales and marketing, 307 were engaged incustomer service and support, 90 were engaged in professional services, and 198were engaged in administrative functions. We believe that we have goodrelations with our employees.

**Item 1A.**                *Risk Factors*

There are many factorsthat affect ISS’ business and the results of its operations, some of which arebeyond ISS’ control. The following is a description of some of the importantfactors that may cause the actual results of ISS’ operations in future periodsto differ materially from those currently expected or desired. We encourage youto read this section carefully.

***We Operate in a Rapidly Evolving Market***

We operate in a rapidlyevolving market and must, among other things:

·       respondto competitive developments;

·       continueto upgrade and expand our product and services offerings; and

·       continueto attract, retain and motivate our employees.

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

We introduced ourProventia appliance line in April 2003 that includes intrusion preventionand integrated security protection. While market response to these products hashad a positive impact on our operating results, failure to continue to gainfurther market acceptance of new appliance products could result in revenuesbelow our expectations and our operating results could be adversely affected.

***Our Future Operating Results Will Likely FluctuateSignificantly***

We cannot predictour future revenues and operating results with certainty. However, we do expectour future revenues and operating results to fluctuate due to a combination offactors, including:

·       theextent to which the public perceives that unauthorized access to and use ofonline information are threats to network security;

·       customerbudgets;

·       themix of product sales among the various products offered by ISS and whetherrevenue is recognized upon sale or deferred to subsequent periods;

·       thevolume and timing of orders, including seasonal trends in customer purchasing;

·       ourability to develop and timely introduce new and enhanced product and managedservice offerings;

·       theintroduction and acceptance rate of new ISS branded appliances, includingrelated increased cost of goods sold;

·       ourability to accurately forecast and produce demanded quantities of our applianceproducts and models;

·       availabilityof component parts of appliance products and reliance on contract manufacturersto produce such products;

·       ourability to provide scalable managed services offerings in a cost effectivemanner;

·       foreigncurrency exchange rates that affect our international operations;

·       whetherenterprises consolidate their security platforms with fewer vendors and whetherISS benefits from this;

·       productand price competition in our markets; and

·       generaleconomic conditions, both domestically and in our foreign markets.

We focus our direct sales efforts on enterprise-widesecurity solutions, which consist of our entire product suite, professionalservices, and managed security services, rather than on the sale of componentproducts. As a result, each sale requires substantial time and effort from oursales and support staff. In addition, the revenues associated with particularsales vary significantly depending on the number of products acquired by acustomer and the number of devices used by the customer. Large individualsales, or even small delays in customer orders, can cause significant variationin our license revenues and results of operations for a particular period. Thetiming of large orders is usually difficult to predict and, like manysoftware-based technology companies, many of our customers typically completetransactions in the last month of a quarter.

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

Our ability to providetimely guidance and meet the expectations of investors with respect to ouroperating and financial results is affected by the tendency of a majority ofour product and license sales to be completed in the last month of a quarter. Wemay not be able to determine whether we will experience material deviationsfrom guidance or expectations until the end of a quarter.

***Dependence on Third Party Suppliers and Manufacturers***

We carry little inventoryof our appliance products and we rely on suppliers to deliver necessarycomponents to our contract manufacturers in a timely manner based on theforecasts we provide. We currently purchase some Proventia appliance componentsand contract manufacturing services from single or limited sources. Ifshortages occur, supplies are interrupted, or we underestimate demand formodels, we may not be able to deliver products to our customers and our revenueand operating results would be adversely affected. We provide forecasts of ourdemand to our contract manufacturers. Because our supply of hardware is basedon short-term forecasts and purchase orders, our contract manufacturers are notobligated to purchase components for greater quantities over longer periods. Ifwe underestimate our requirements, our contract manufacturers may have aninadequate component inventory and, based on lead times, this could interruptmanufacturing and result in delays in shipments and revenues.

***We Face Intense Competition in Our Market***

The market fornetwork security monitoring, detection, prevention and response solutions isintensely competitive, and we expect competition to increase in the future. Wecannot guarantee that we will compete successfully against our current orpotential competitors, especially those with significantly greater financialresources or brand name recognition. Our chief competitors generally fallwithin the following categories:

·       largecompanies, including Symantec Corporation, Cisco Systems, Inc., JuniperNetworks, Inc., 3Com Corporation, Check Point Software Technologies, LTD,and McAfee, Inc., that sell competitive products and offerings, as well asother large software companies that have the technical capability and resourcesto develop competitive products;

·       softwareor hardware network infrastructure companies like Cisco Systems, Inc.,3Com Corporation, and Juniper Networks, Inc. that could integrate featuresthat are similar to our products into their own products;

·       smallersoftware companies offering relatively limited applications for network andInternet security; and

·       smalland large companies with competitive offerings to components of our managedservices offerings.

Mergers or consolidations among these competitors, oracquisitions of small competitors by larger companies, represent risks. Forexample, Symantec Corporation., Cisco Systems, Inc., McAfee, Inc.,3Com Corporation, and Juniper Networks, Inc. have acquired during the pastseveral years smaller companies, which have intrusion detection or preventiontechnologies. These acquisitions will make these entities potentially moreformidable competitors to us if such products and offerings are effectivelyintegrated. Large companies may have advantages over us because of their longeroperating histories, greater name recognition, larger customer bases or greaterfinancial, technical and marketing resources. As a result, they 

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may be able to adapt morequickly to new or emerging technologies and changes in customer requirements. Theycan also devote greater resources to the promotion and sale of their productsthan we can. In addition, these companies have reduced and could continue toreduce, the price of their security monitoring, detection, prevention andresponse products and managed security services, which increases pricingpressures within our market.

Several companies currently sell software products(such as encryption, firewall, operating system security and virus detectionsoftware) that our customers and potential customers have broadly adopted. Someof these companies sell products that perform the same functions as some of ourproducts. In addition, the vendors of operating system software or networkinghardware may enhance their products to include the same kinds of functions thatour products currently provide. The widespread inclusion of comparable featuresto our software in operating system software or networking hardware couldrender our products less competitive or obsolete, particularly if such featuresare of a high quality. Even if security functions integrated into operatingsystem software or networking hardware are more limited than those of ourproducts, a significant number of customers may accept more limitedfunctionality to avoid purchasing additional products.

In addition, with the introduction of our Proventiaintegrated security appliance, we have offerings that compete with vendors offirewalls, VPNs, anti-virus systems, and content and spam filtering products. Theseofferings are competitive with a broader spectrum of network securitycompanies, as well as those that also offer integrated security appliances orbroad product suites.

For the above reasons, wemay not be able to compete successfully against our current and futurecompetitors. Increased competition may result in price reductions, reducedgross margins and loss of market share.

***We Face Risks Associated with Governmental Contracting***

Our customersinclude the U.S. and other national government agencies and a significantnumber of other state and local governments or agencies.

·       Procurement—Contractingwith public sector customers is highly competitive and can be expensive andtime-consuming, often requiring that we incur significant upfront time andexpense without any assurance that we will win a contract;

·       BudgetaryConstraints and Cycles—Demand and payment for our products and services areimpacted by public sector budgetary cycles and funding availability, withfunding reductions or delays adversely impacting public sector demand for ourproducts and services;

·       Modificationor Cancellation of Contracts—Public sector customers often have contractual orother legal rights to terminate current contracts for convenience or due to adefault. If a contract is cancelled for convenience, which can occur if thecustomer’s product needs change, we may only be able to collect for productsand services delivered prior to termination. If a contract is cancelled becauseof default, we may only be able to collect for products and alternativeproducts and services;

·       Governmental Audits—Nationalgovernments and other state and local agencies routinely investigate and auditgovernment contractors’ administrative processes. They may audit ourperformance and pricing and review our compliance with applicable rules andregulations. If they find that we improperly allocated costs, they may requireus to refund those costs or may refuse to pay us for outstanding balancesrelated to the improper allocation. An unfavorable audit could result in areduction of revenue, and may result in civil or criminal liability if theaudit uncovers improper or illegal activities.

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***We Face Rapid Technological Change in Our Industry andFrequent Introductions of New Products***

Rapid changes intechnology pose significant risks to us. We do not control nor can we influencethe forces behind these changes, which include:

·       theextent to which businesses and others seek to establish more secure networks;

·       theextent to which hackers and others seek to compromise secure systems;

·       evolvingcomputer hardware and software standards;

·       changingcustomer requirements; and

·       frequentintroductions of new products and product enhancements.

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

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

The techniques computerhackers use to gain unauthorized access to, or to sabotage, networks andintranets are constantly evolving and increasingly sophisticated. Furthermore,because new hacking techniques are usually not recognized until used againstone or more targets, we are unable to anticipate most new hacking techniques. Tothe extent that new hacking techniques harm our customers’ computer systems orbusinesses, affected or prospective customers may believe that our products areineffective, which may cause them or prospective customers to reduce or avoidpurchases of our products.

***Undetected ProductErrors or Defects Could Result in Loss of Revenues, Delayed Market Acceptanceand Claims Against Us***

We offer warranties on our products, allowing the endcustomer to have any defective product repaired, or to receive a replacementproduct for it during the warranty period, or in certain circumstances returnthe product for a refund. Our products may contain undetected errors or defects.If there is a broad product failure across our customer base, we may decide toreplace all affected products or we may decide to refund the purchase price fordefective units. Such defects and actions may adversely affect our ability torecord revenue. Some errors are discovered only after a product has beeninstalled and used by end customers. Any errors discovered after commercialrelease could result in loss of revenues and claims against us.

We offer warranties on our service levels for managedsecurity services. If we do not meet warranties, the customer generally mayobtain credits for service.

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If we are unable tofix errors or other product problems that later are identified after fulldeployment, or if we fail to meet our service levels for managed securityservices, in addition to the consequences described above, we could experience:

·       failureto achieve market acceptance;

·       lossof customers;

·       lossof or delay in revenues and loss of market share;

·       diversionof development resources;

·       increasedservice and warranty costs;

·       legalactions by our customers; and

·       increased insurance costs.

***Our Products areComplex and Are Operated in a Wide Variety of Computer Configurations, WhichCould Result in Errors or Product Failures***

Because we offer very complex products, undetectederrors, failures or bugs may occur when they are first introduced or when newversions are released. Our products often are installed and used in large-scalecomputing environments with different operating systems, system managementsoftware and equipment and networking configurations, which may cause errors orfailures in our products or may expose undetected errors, failures or bugs inour products. We discover errors, failures and bugs in certain of our productofferings after their introduction and have experienced delays and couldexperience lost revenues during the period required to correct these errors. Ourcustomers’ computer environments are often characterized by a wide variety ofstandard and non-standard configurations that make pre-release testing for programmingor compatibility errors very difficult and time-consuming. Despite testing,errors, failures or bugs may not be found in new products or releases untilafter commencement of commercial shipments. Errors, failures or bugs inproducts released by us could result in negative publicity, product returns,loss of or delay in market acceptance of our products or claims by customers orothers.

In addition, if an actualor perceived breach of network security occurs in one of our end customer’ssecurity systems, regardless of whether the breach is attributable to ourproducts, the market perception of the effectiveness of our products could beharmed. Because the techniques used by computer hackers to access or sabotagenetworks change frequently and generally are not recognized until launchedagainst a target, we may be unable to anticipate these techniques. Alleviatingany of these problems could require significant expenditures of our capital andresources and could cause interruptions, delays or cessation of our productlicensing, which could cause us to lose existing or potential customers andwould adversely affect results of operations.

***We Might Have toDefend Lawsuits or Pay Damages in Connection With Any Alleged or Actual Failureof Our Products and Services***

Because our products andservices provide and monitor network security and may protect valuableinformation, we could face claims for product liability, tort or breach ofwarranty. Anyone who circumvents our security measures could misappropriate theconfidential information or other property of end customers using our products,or interrupt their operations. If that happens, affected end customers orothers may sue us. In addition, we may face liability for breaches caused byfaulty installation of our products by our service and support organizations. Provisionsin our contracts relating to warranty disclaimers and liability limitations maybe unenforceable. Some courts, for example, have found contractual limitationsof liability in standard computer and software contracts to be unenforceable insome circumstances. Defending a lawsuit, regardless of its merit, could becostly and could divert 

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managementattention. Our business liability insurance coverage may be inadequate orfuture coverage may be unavailable on acceptable terms or at all.

***Risks Associated with Our Global Operations***

The expansion ofour international operations includes our presence in dispersed locationsthroughout the world, including throughout EMEA and the Asia/Pacific and LatinAmerica regions. Our international presence and expansion exposes us to risksnot present in our U.S. operations, such as:

·       thedifficulty in managing an organization spread over various countries locatedacross the world;

·       compliancewith, and unexpected changes in, a wide range of complex regulatoryrequirements in countries where we do business;

·       dutiesand tariffs imposed on importation of our products in other jurisdictions whereother manufacturers may not bear those same costs;

·       increasedfinancial accounting and reporting burdens;

·       potentiallyadverse tax consequences;

·       fluctuationsin foreign currency exchange rates resulting in losses or gains fromtransactions and expenses denominated in foreign currencies;

·       reducedprotection for intellectual property rights in some countries;

·       reducedprotection for enforcement of creditor and contractual rights in somecountries; and

·       importand export license requirements and restrictions on the import and export ofcertain technology, especially encryption technology and trade restrictions.

Despite these risks, webelieve that we must continue to expand our operations in international marketsto support our growth. To this end, we intend to establish additional foreignsales operations, expand our existing offices, hire additional personnel,expand our international sales channels and customize our products for localmarkets. If we fail to execute this strategy, our international sales growthwill be limited.

***Our Networks, Products and Services May beTargeted by Hackers***

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

***We Must Successfully Integrate Acquisitions***

As part of our growthstrategy, we have and may continue to acquire or make investments in companieswith products, technologies or professional services capabilities complementaryto our solutions. When engaging in acquisitions, we could encounterdifficulties in assimilating or completing the development of the technologies,new personnel and operations into our company. These difficulties may disruptour ongoing business, distract our management and employees, increase ourexpenses and adversely affect our results of operations. These difficultiescould also include accounting requirements, such as impairment charges relatedto goodwill or other intangible assets or expensing in-process research anddevelopment costs. We cannot be certain that we will successfully overcomethese risks with respect to any future acquisitions or that we will notencounter other problems in connection with our recent or any 

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futureacquisitions. In addition, any future acquisitions may require us to incur debtor issue equity securities. The issuance of equity securities could dilute theinvestment of our existing stockholders.

***We Have Authorizedthe Use of a Substantial Amount of Our Cash for the Repurchase of Our Shares,and This Use of Funds May Limit Our Ability to Complete Other Transactionsor to Pursue Other Business Initiatives.***

In July 2005, ISSannounced a share repurchase program authorizing the use of up to $100 millionin cash to repurchase outstanding shares of our common stock. We expect torepurchase shares for cash as business conditions warrant through July 19,2006. The full implementation of this repurchase program would use asignificant portion of our cash reserves. This use of cash could limit ourfuture flexibility to complete acquisitions of businesses or technology orother transactions.

***Our Proprietary Rights May be Difficult toEnforce***

We rely primarily oncopyright, trademark, patent and trade secrets laws, confidentiality proceduresand contractual provisions to protect our proprietary rights. We hold several UnitedStates patents, one Taiwanese patent, and have a number of patent applicationspending. We also hold numerous United States and foreign trademarks and have a numberof trademark applications pending. There can be no assurance that patents willbe issued from pending applications, or that claims allowed on any patents willbe sufficiently broad to protect our technology. There can be no assurance thatany issued patents will not be challenged, invalidated or circumvented, or thatany rights granted under these patents will actually provide competitiveadvantages to us. Despite our efforts to protect our proprietary rights,unauthorized parties may attempt to copy aspects of our products or to obtainand use information that we regard as proprietary. Policing unauthorized use ofour products is difficult. While we cannot determine the extent to which piracyof our software products occurs, we expect software piracy to be a persistentproblem. In addition, the laws of some foreign countries do not protect ourproprietary rights to as great an extent as do the laws of the United States,and many foreign countries do not enforce these laws as diligently asU.S. government agencies and private parties. If we are unable to protectour proprietary rights to the totality of the features in our software andproducts (including aspects of our software and products protected other thanby patent rights), we may find ourselves at a competitive disadvantage toothers who need not incur the additional expense, time and effort required tocreate the innovative products that have enabled us to be successful.

***We May Be Found to Infringe the ProprietaryRights of Others***

Third parties may assertclaims or initiate litigation related to exclusive patent, copyright, trademarkand other intellectual property rights to technologies that are relevant to ourbusiness. Because of the large number of patents in the Internet, networking,security and software fields, the secrecy of some pending patents and the rapidrate of issuance of new patents, it is not economically practical (or evenpossible) to determine in advance whether a product (or any of its components)infringe or will infringe the patent rights of others. Third party assertedclaims and/or initiated litigation can include claims against us or ourmanufacturers, suppliers, or customers, alleging infringement of proprietaryrights with respect to our existing or future products (or components of thoseproducts). Regardless of the merit of these claims, they can be time-consuming,result in costly litigation and diversion of technical and managementpersonnel, or require us to develop a non-infringing technology or enter intolicense agreements. There can be no assurance that licenses will be availableon acceptable terms and conditions, if at all, in these circumstances, or thatany indemnification that might be available to us would be adequate to coverour costs of defense. Furthermore, because of the potential for largejudgments, which are not necessarily predictable, it is not unusual to findeven arguably unmeritorious claims settled for significant funds. If anyinfringement or other intellectual property claims made against us by a thirdparty is successful, or if we fail to develop non-infringing technology orlicense the proprietary rights on commercially reasonable terms 

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andconditions, our business, operating results, financial condition and liquiditycould be materially and adversely affected.

***Some Provisions in the ISS Certificate ofIncorporation and Bylaws Make a Takeover of ISS Difficult***

Our certificate ofincorporation and bylaws contain provisions that could have the effect ofmaking it more difficult for a third party to acquire, or of discouraging athird party from attempting to acquire, control of ISS. These provisions:

·       establisha classified board of directors;

·       createpreferred stock purchase rights that grant to holders of common stock the rightto purchase shares of Series A Junior Preferred Stock in the event that athird party acquires 20% or more of the voting power of our outstanding commonstock;

·       prohibitthe right of our stockholders to act by written consent;

·       limitcalling special meetings of stockholders; and

·       impose a requirement thatholders of 662¤3%of the outstanding shares of common stock are required to amend the provisionsrelating to the classification of our board of directors and action by writtenconsent of stockholders.

**Item 1B.**               *Unresolved Staff Comments*

None.

**Item 2.**                        *Properties*

We currently lease three buildings totalingapproximately 289,000 square feet in Atlanta, Georgia for our headquartersand research and development facility. The lease on these three buildingsexpires in May 2013.

We lease additional office space in Chicago, Illinois;Southfield, Michigan; New York, New York; Paramus, New Jersey andWashington, D.C., as well as small executive suites in a number of UnitedStates cities. In addition, we lease office space in Toronto, Canada; SaoPaulo, Rio de Janeiro, and Brasilia, Brazil; Buenos Aires, Argentina; Bogota,Columbia; Mexico City, Mexico; Brussels, Belgium; London, England; Paris,France; Kassel and Stuttgart, Germany; Stockholm, Sweden; Milan, Rome andPadua, Italy; Madrid, Spain; Zurich, Switzerland; Amsterdam, Netherlands;Warsaw, Poland; Cairo, Egypt; Seoul, Korea; Brisbane, Australia; Singapore;Beijing, China; and Osaka and Tokyo, Japan.

We believe that ourexisting facilities are adequate for our current needs and that additionalspace will be available as needed.

**Item 3.**                        *Legal Proceedings*

On August 17, 2004,the Company’s Georgia operating subsidiary filed in the United States DistrictCourt for the Northern District of Georgia a declaratory judgment action (the “GeorgiaAction”) against SRI International, Inc. (“SRI”). The action seeks thecourt’s declaration that our products and services do not infringe any validclaim of five patents held by SRI and seeks declaration that certain claims ofthose patents are invalid. On August 26, 2004, SRI filed in the UnitedStates District Court for Delaware a complaint against the Company and SymantecCorporation (the “Delaware Action”). The complaint in the Delaware Actionalleges that our SiteProtector and Proventia products infringe upon claims oftwo of the five patents at issue in the Georgia Action. The Delaware Actionseeks unspecified damages and injunctive relief. On April 25, 2005, SRIfiled an amended complaint adding the Company’s Georgia operating 

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subsidiaryas a separate defendant to the Delaware Action. The Company and its subsidiaryanswered SRI’s amended complaint on May 23, 2005, denying that theyinfringe the two patents asserted by SRI and asserting counterclaims seeking adeclaration from the Delaware court that the five SRI patents are notinfringed, and are invalid and unenforceable. On June 9, 2005, the Georgiacourt transferred the Georgia Action to the United States District Court forthe District of Delaware. The transferred action was consolidated with theDelaware Action. On June 13, 2005, SRI answered the counterclaims assertedby the Company and its subsidiary, denying that the five patents are notinfringed, invalid, and unenforceable. On August 5, 2005, SRI granted tothe Company a covenant never to sue the Company, its distributors, customers,licensees or end users, for damages or any other form of legal or equitablerelief based on or arising out of the alleged infringement of one of the fivepatents-in-suit as a result of the manufacture, use, sale, offer for sale,importation, maintenance, support or servicing of any Company product orservice existing on or before the effective date. The parties are currentlyengaged in discovery on the remaining claims, and trial has been scheduled tobegin on or about October 30, 2006. We intend to defend the DelawareAction vigorously and believe we have meritorious defenses and counterclaims.

**Item 4.**                        *Submission of Matters to a Vote of Security Holders*

No matter was submitted to a vote of our stockholdersduring the fourth quarter of 2005.

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**PART II**

**Item 5.**                        *Market for Registrant’s Common Equity and Related Stockholder Mattersand Issuer Purchases of Equity Securities*

OurCommon Stock is quoted on the Nasdaq National Market under the symbol “ISSX”. Thefollowing table lists the high and low per share sales prices for the CommonStock as reported by the Nasdaq National Market for the periods indicated:

| **2005:**      | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 23.49      |     | $          | 17.57   |       |
| Second Quarter |       | 23.43      |       | 16.44    |       |
| Third Quarter  |       | 25.20      |       | 19.88    |       |
| Fourth Quarter |       | 25.40      |       | 20.66    |       |
|                |            |            |            |          |            |         |            |  |  |

 

| **2004:**      | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 21.21      |     | $          | 15.65   |       |
| Second Quarter |       | 19.25      |       | 12.98    |       |
| Third Quarter  |       | 17.25      |       | 12.60    |       |
| Fourth Quarter |       | 25.76      |       | 16.86    |       |
|                |            |            |            |          |            |         |            |  |  |

 

As of February 23, 2006, there were 44,763,166 sharesof our Common Stock outstanding held by 230 stockholders of record.

We have never declared nor paid cash dividends on ourcapital stock. We intend to retain any earnings for use in our business and donot anticipate paying any cash dividends in the foreseeable future. Our Boardof Directors will determine future dividends, if any.

On October 29, 2003, ISS announced a voluntaryoption exchange program intended to reduce the number of outstanding options. Stockoptions with exercise prices exceeding $30 per share were eligible. Ourdirectors and five most senior executive officers, including the chiefexecutive officer, were not eligible to participate in the program. Approximately783,000 of the 1,343,000 eligible option shares with exercise prices between$30 and $83 per share elected to participate in the program and theseoptions were cancelled on November 27, 2003. New options totalingapproximately 313,000 shares were issued on June 1, 2004. Thistransaction is exempt from registration under Section 3(a)(9) of theSecurities Act of 1933.

Information on oursecurities authorized for issuance under our equity compensation plans isincorporated by reference from our Proxy Statement for our 2006 Annual Meetingof Stockholders to be filed with the Securities and Exchange Commission inItem 12 of Part III of this Annual Report on Form 10-K.

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**Purchases of Equity Securities**

Thefollowing table provides information about purchases by the Company of itscommon stock during the three months ended December 31, 2005. All suchpurchases were made in open-market transactions pursuant to a repurchase planpublicly announced on July 27, 2005. Under this repurchase plan, theCompany has been authorized by the Board to repurchase up to $100 million ofits outstanding common stock over the 12 months ending July 19, 2006. TheCompany had prior repurchase plans in place that have terminated, and nofurther purchases can be made under those plans. Through December 31,2005, the Company had purchased approximately 7.1 million shares at anaggregate cost of approximately $124.3 million under the current and priorrepurchase plans.

| ** **       | ** ** | ** **                    | ** ** | ** **                | ** ** | ** **                             | ** ** | **Approximate**                       | ** ** |
|------------------|------------|-------------------------------|------------|---------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **       | ** ** | ** **                    | ** ** | ** **                | ** ** | **Total Number of**          | ** ** | **Dollar Value of**         | ** ** |
| ** **       | ** ** | ** **                    | ** ** | ** **                | ** ** | **Shares Purchased**              | ** ** | **Shares that May**         | ** ** |
| ** **       | ** ** | ** **                    | ** ** | ** **                | ** ** | **as Part of Publicly** | ** ** | **Yet Be Purchased**        | ** ** |
| ** **       | ** ** | **Total Number of** | ** ** | **Average Price**    | ** ** | **Announced Plans**               | ** ** | **Under the Plans or** | ** ** |
| **Period**       | ** ** | ** **                    | ** ** | **Shares Purchased** | ** ** | **Paid Per Share**           | ** ** | **or Programs**                  | ** ** | **Programs** | ** ** |
| 10/1/05-10/31/05 |       |                          | 17,500     |                      |       |                                   | $          | 23.99                                 |       |   |   | 17,500 |   |   |   | $ | 82,471,000 |   |   |
| 11/1/05-11/30/05 |       |                          | 340,000    |                      |       |                                   | $          | 24.19                                 |       |   |   | 340,000 |   |   |   | $ | 74,246,000 |   |   |
| 12/1/05-12/31/05 |       |                          | 260,000    |                      |       |                                   | $          | 22.44                                 |       |   |   | 260,000 |   |   |   | $ | 68,412,000 |   |   |
|                  |            |                               |            |                           |            |                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 6.**                        *Selected Financial Data*

Thefollowing selected consolidated financial data should be read in conjunctionwith the consolidated financial statements and the notes thereto in Item 8of Part II, “Financial Statements and Supplementary Data,” and theinformation contained in Item 7 of Part II, “Management’s Discussionand Analysis of Financial Condition and Results of Operations.” Historicalresults are not necessarily indicative of future results.

| ** **                                                              | ** ** | **Year Ended December 31,**                                         | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                              | ** ** | **(amounts in thousands, except per share amounts)** | ** ** |
| **Consolidated Statement of  Operations Data:**                         |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Revenues                                                                |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Product licenses and  sales                                             |       | $                                                                                  | 146,347    |   | $ | 126,112 |   | $ | 107,117 |   | $ | 121,093 |   | $ | 122,385 |   |
| Subscriptions                                                           |       | 161,101                                                                            |       | 140,693 |   | 112,855 |   | 92,945 |   | 66,687 |   |
| Professional services                                                   |       | 22,324                                                                             |       | 23,088 |   | 25,809 |   | 29,247 |   | 34,487 |   |
| Total revenues                                                          |       | 329,772                                                                            |       | 289,893 |   | 245,781 |   | 243,285 |   | 223,559 |   |
| Cost of revenues                                                        |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Cost of product licenses  and sales(1)                                  |       | 28,853                                                                             |       | 22,388 |   | 9,528 |   | 6,688 |   | 13,439 |   |
| Amortization of acquired  technology                                    |       | 6,985                                                                              |       | 6,851 |   | 4,404 |   | 3,649 |   | 2,624 |   |
| Cost of subscriptions and  services                                     |       | 52,829                                                                             |       | 48,999 |   | 48,686 |   | 51,133 |   | 50,708 |   |
| Total cost of revenues                                                  |       | 88,667                                                                             |       | 78,238 |   | 62,618 |   | 61,470 |   | 66,771 |   |
| Research and development                                                |       | 45,177                                                                             |       | 42,976 |   | 41,843 |   | 35,280 |   | 35,413 |   |
| Sales and marketing                                                     |       | 108,908                                                                            |       | 100,966 |   | 87,452 |   | 93,679 |   | 92,001 |   |
| General and  administrative                                             |       | 30,182                                                                             |       | 27,568 |   | 22,661 |   | 24,271 |   | 20,442 |   |
| Write-off of lease obligation                                           |       | —                                                                             |       | — |   | — |   | — |   | 1,072 |   |
| Charge for in-process  research and development(2)                      |       | —                                                                             |       | — |   | — |   | 18,537 |   | 2,910 |   |
| Amortization of goodwill(3)                                             |       | —                                                                             |       | — |   | — |   | — |   | 26,505 |   |
| Amortization and  write-off of intangibles and stock-based compensation |       | 167                                                                                |       | 402 |   | 1,611 |   | 2,025 |   | 2,603 |   |
| Operating income (loss)                                                 |       | 56,671                                                                             |       | 39,743 |   | 29,596 |   | 8,023 |   | (24,158 | ) |
| Interest income                                                         |       | 5,724                                                                              |       | 2,517 |   | 2,683 |   | 3,242 |   | 6,250 |   |
| Other income (expense),  net                                            |       | (1,674                                                                             | )          | (866 | ) | (1,560 | ) | 990 |   | (229 | ) |
| Gain on issuance of  subsidiary stock                                   |       | 220                                                                                |       | 292 |   | 249 |   | 2,600 |   | 15,200 |   |
| Income (loss) before  income taxes                                      |       | 60,941                                                                             |       | 41,686 |   | 30,968 |   | 14,855 |   | (2,937 | ) |
| Provision for income  taxes                                             |       | 22,396                                                                             |       | 15,393 |   | 11,231 |   | 13,076 |   | 12,521 |   |
| Net income (loss)                                                       |       | $                                                                                  | 38,545     |   | $ | 26,293 |   | $ | 19,737 |   | $ | 1,779 |   | $ | (15,458 | ) |
| Diluted net income (loss) per share                                     |       | $                                                                                  | 0.82       |   | $ | 0.54 |   | $ | 0.39 |   | $ | 0.04 |   | $ | (0.34 | ) |

 

| ** **                               | ** ** | **December 31,**                | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|
| ** **                               | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                               | ** ** | **(amounts in thousands)** | ** ** |
| **Consolidated Balance Sheet  Data:**    |       |                                 |       |   |   |   |   |   |   |   |   |
| Cash and marketable  securities          |       | $                                    | 238,893    |   | $ | 211,049 |   | $ | 238,181 |   | $ | 202,316 |   | $ | 163,167 |   |
| Goodwill, less  accumulated amortization |       | 220,224                              |       | 224,065 |   | 201,303 |   | 200,464 |   | 197,060 |   |
| Total assets                             |       | 618,644                              |       | 598,902 |   | 581,282 |   | 546,568 |   | 500,984 |   |
| Stockholders’ equity                |       | 486,140                              |       | 481,580 |   | 486,343 |   | 464,556 |   | 426,935 |   |
|                                          |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)   In 2003 theCompany introduced the Proventia family of network protection appliances. Thesubstantial portion of cost of product licenses and sales represents thehardware cost of the Proventia appliances.

(2)   During 2002and 2001 the Company recorded write-offs of in-process research and developmentassociated with the 2002 acquisition of vCIS and the 2001 acquisition ofNetwork ICE, as the technology had not reached technological feasibility at thetime of the acquisition.

(3)   On January1, 2002 the Company adopted Statement of Financial Accounting Standards(“SFAS’’) No. 142, *Goodwill and OtherIntangible Assets.* Pursuant to SFAS No. 142, the Company ceasedamortizing goodwill.

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**Item 7.**                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*

*The following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations should be read in conjunctionwith the Consolidated Financial Statements and related Notes thereto includedelsewhere in this Form 10-K. Except for the historical financialinformation, many of the matters discussed in this Item 7 may beconsidered “forward-looking” statements. Such forward-looking statements arenot guarantees of future performance and involve a number of risks anduncertainties. Many of the risks and uncertainties are described below underthe caption “Risk Factors”.*

**Overview**

We focus on providing enterprise-wide pre-emptiveprotection. We provide such protection with our comprehensive line of productsand services. These include a product family consisting of network and hostintrusion prevention, integrated security appliances, desktop protection andvulnerability protection; ISS’ SiteProtector centralized management system; andISS’ Managed Security Services and Professional Security Services. Theintegrated security appliance includes, in addition to intrusion prevention,firewalls, virtual private network features, anti-virus protection, content filteringand e-mail security, including anti-spam technology.

This combination of products and services forms ourProventia Enterprise Security Platform (ESP), which contributes to businessprocess optimization by maintaining a delicate balance between IT-performance,availability and risk—ultimately stopping cyber threats before they impactoperations. Unlike traditional approaches to security, which focus on improvingreaction times, Proventia ESP is designed to avoid security incidents bycombining continuous vulnerability assessment and threat prevention withenterprise-wide information management and reporting capabilities. Ourobjective is to enable companies to shield security vulnerabilities acrosstheir entire IT infrastructure—before attacks are released.

We currently plan to continue to evolve the ProventiaEnterprise Security Platform by further automating enterprise security policyand delivering it within the context of existing IT processes.

Our managed services offerings currently provide remotemanagement of our best-of-breed security technology, focusing on securityassessment and intrusion detection, intrusion prevention and desktop protectionsystems, and include firewalls, VPNs, anti-virus and URL filtering software. Wefocus on serving as the trusted security provider to our customers bymaintaining within our existing products the latest counter-measures tosecurity risks, creating new innovative products based on our customers’ needsand providing professional and managed services.

Many factors will affectour future financial performance, especially our ability to differentiate ourofferings from competitors that include much larger companies with greatermarketing capabilities, financial resources and brand recognition. In order tocontinue to create such differentiation, we expect to continue to expand ourdomestic and international sales and marketing operations, seek acquisitioncandidates and alliances with partners whose products, technologies or servicecapabilities are complementary to our solutions; and improve our internaloperating and financial infrastructure in support of our strategic goals andobjectives. At the same time, we expect to adjust our organization size inlight of changing economic conditions and maintain emphasis on controllingdiscretionary spending and capital expenditures. While we believe in thelong-term success of our business solutions, our prospects must be consideredin light of the recent experience, risks and difficulties that are frequentlyencountered by companies serving rapidly evolving markets. See “Risk Factors”.

**CriticalAccounting Policies**

The consolidated financialstatements were prepared in conformity with U.S. generally acceptedaccounting principles (“GAAP”). As such, management is required to make certainestimates, judgments 

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andassumptions it believes are reasonable based upon the information available. Theseestimates and assumptions affect the reported amounts of assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the periods presented. Actual results may differsignificantly from these estimates under different assumptions, judgements, orconditions. The significant accounting policies which management believes arethe most critical to aid in fully understanding and evaluating our reportedfinancial results include the following:

***Revenue recognition***

We recognizerevenue in the following categories:

·       *Product licenses and sales,* which include revenue from salesof perpetual software licenses and products;

·       *Subscription revenues,* which consists ofcustomer support, including content updates and technical support, termlicenses, subscription licenses and managed service arrangements; and

·       *Professional services revenues,* whichincludes fee-based service engagements and training.

We recognizesoftware license revenue under the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) 97-2,*Software Revenue Recognition,* as modifiedby SOP 98-9,*Software RevenueRecognition with Respect to Certain Transactions,* when the followingcriteria have been met:

·       persuasiveevidence of an arrangement exists;

·       deliveryhas occurred or services have been rendered;

·       priceis fixed or determinable; and

·       collection is probable.

*Product licensesand sales*

We recognize perpetual software license revenues,assuming all other revenue recognition criteria are met, upon (1) deliveryof the software and (2) issuance of the related license, assuming that nosignificant vendor obligations or customer acceptance rights exist. Wherepayment terms are extended, revenue is recognized as such amounts become dueand payable. Revenue is also deferred when sales are deemed either not to befixed or determinable or collection is not probable based on evaluation of allterms of the transaction.

Product sales consist primarily of appliances sold inconjunction with ISS licensed software. These sales are recognized uponshipment to the customer provided all other criteria for software licenserevenue recognition are met.

Sales of products aregenerated both through direct sales to end-users as well as through variouspartners, including system integrators, value-added resellers and distributors.Revenue from product licenses and sales is recognized when the sale hasoccurred for an identified end-user, provided all other revenue recognitioncriteria are met. At the point of delivery, the customer has no right of return.We offer evaluation software available via download from our website andevaluation units for appliance-based products that allow potential customers tosee the functionality of the products on their own networks prior to purchase.

*Subscriptionrevenues*

Subscription revenuesconsist of renewable customer support, term licenses and security monitoringand management services. Renewable customer support is a separate element ofsales of perpetual 

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softwarelicenses and products. Term licenses allow customers to use our products andreceive product support coverage and content updates for a specified period,generally twelve months. We generally invoice for customer support and termlicenses at the beginning of the term and recognize revenue ratably over thesubscription term. Security monitoring and management services for informationassets and systems are part of managed services and associated revenues arerecognized as such services are rendered.

Historically, our softwareand intrusion prevention appliance sales have been accounted for primarily asrevenue at the time of sale, with product support and content updates generallyrepresenting between 20% and 30% of the related license or product amount. Priorto the second quarter of 2005, the majority of the initial price paid by thecustomer for certain Proventia integrated security appliance models was forselected content updates (sometimes referred to as “blades”), which customersacquire for a specified term that is recognized over such term as subscriptionrevenue. During the second quarter of 2005, we changed the pricing model forour Proventia integrated security appliances to our historical model underwhich customers acquire the appliance bundled with most content blades, whichare recorded as product revenue at the time of sale, and pay annual customersupport fees at an average rate of 22% of the related product price. Thischange did not have a material impact on our results.

*Professional services revenues*

Service engagements aretypically billed on either a fixed fee or time-and-materials basis andprimarily consist of security assessments of customer networks and thedevelopment of customers’ security policies. These offerings are intended tosupport our goal of providing products and managed services. We prefer to haveour partners provide these services where practical. We recognize suchprofessional services revenues as the related services are rendered.

*Multiple elements arrangements*

Oursales of product and/or software licenses are multiple element arrangementsthat include product support and content updates and may include othersubscription or professional services delivered after the product or softwarelicense. Revenue is generally recognizable before delivery of every element ofthe arrangement when all of the following requirements exist:

·       vendorspecific objective evidence (“VSOE”) of fair value exists for the undeliveredelements;

·       thefunctionality of the delivered elements is not dependent on the undeliveredelements; and

·       deliveryof the delivered elements represents the culmination of the earnings process.

We recognize thedifference between the total arrangement fee and the amount deferred for theundelivered elements as revenues by allocating revenue to the deliveredproducts, licenses and services using the residual method. Under theresidual method, we allocate discounts inherent in the arrangement to productsand customer support associated with products that are initially delivered andrecognize the other elements as they are delivered based on the VSOE of fairvalue, which is determined based on transactions where the company sells thoseelements separately. We determine fair value of the undelivered elements basedon historical evidence of our stand-alone sales of these elements to thirdparties.

***Allowance for doubtful accounts***

Our sales are global,with customers located in the Americas, EMEA, and Asia/Pacific regions. Weperform periodic credit evaluations of our customer’s financial condition anddo not require collateral. We provide for estimated credit losses as suchlosses become probable. We evaluate specific accounts when we become aware of asituation where a customer may not be able to meet its financial obligationsdue to deterioration of its liquidity or financial viability, credit ratings orbankruptcy. The allowance for doubtful 

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accountsis established based on the best facts available to us and is reevaluated andadjusted as additional information is received. At December 31, 2005, theallowance for doubtful accounts totaled $3.6 million, or 3.9% of the$91.3 million of total trade receivables. This 3.9% allowance ofreceivables reflects our practice to leave accounts on our general ledger andprovide reserves pending final resolution of collectibility rather than towrite-off such accounts.

Our bad debt expense for the year ended December 31,2005 amounted to $1.2 million compared to $1.2 million in 2004 and$1.1 million in 2003. The provision for 2005 was a lower percentage oftotal revenues compared to 2004 and 2003 due to the continued absence of anysignificant new identified exposures for the third straight year.

In January 2004, a new distributor for Chinaassumed the rights and the obligations of the distribution agreement for ISSproducts from a prior distributor. In connection with this agreement, wemodified the new distributor’s obligations, which resulted in an additional$200,000 of bad debt expense recorded in the fourth quarter of 2003 and thewrite-off of $1.1 million against the allowance account. We established afirm repayment schedule and received timely payments under this schedule, whichresulted in full payment of the receivable by the first quarter of 2005.

While actual credit losseshave historically been within management’s expectations and the provisionsestablished, we cannot guarantee that we will continue to experience the samecredit loss rates we have in the past. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required.

*Impairment ofgoodwill and other long-lived and intangible assets*

We review goodwill for impairment on an annual basisor on an interim basis whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. All otherlong-lived and intangible assets are reviewed for impairment whenever events orcircumstances indicate that the carrying amount of an asset may not berecoverable. Such impairment loss would be measured as the difference betweenthe carrying amount of the asset and its fair value based on the present valueof estimated future cash flows. Significant judgment is required in theforecasting of future operating results, which are used in the preparation ofprojected cash flows. Due to uncertain market conditions and potential changesin our strategy and products, it is possible that forecasts used to support ourintangible assets may change in the future, which could result in significantnon-cash charges that would adversely affect our results of operations.

We currently have goodwilland other acquisition related intangibles of approximately $231 million,with $195 million of goodwill related to our June 2001 acquisition ofNetwork ICE Corporation (“Network ICE”) and $19 million of goodwillrelated to the January 2004 acquisition of Cobion, a privately heldcompany based in Kassel, Germany (“Cobion”). The determination of whether ornot goodwill is impaired involves significant judgments based upon short andlong-term projections of future performance. We have concluded that this amountis realizable based on forecasted discounted cash flows through 2009 and on ourstock market valuation. Neither method indicated that our goodwill had beenimpaired and, as a result, we did not record any impairment losses related togoodwill during the year ended December 31, 2005. Other intangibles ofapproximately $11 million are principally acquired technology from theNetwork ICE and Cobion acquisitions that are components in our current productofferings.

*Recently IssuedAccounting Standards*

On December 16, 2004, the Financial AccountingStandards Board issued SFAS No. 123 (revised 2004) (“SFAS No. 123(R)”),*Share-Based Payment,*which is a revisionof SFAS No. 123, *Accounting for Stock-BasedCompensation*. SFAS No. 123(R) supersedes APB No. 25and revises guidance in SFAS No. 123. Among other things, SFAS No. 123(R) requiresthat compensation expense be recognized 

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in the financialstatements for share-based awards based on the grant date fair value of thoseawards. It will also require the benefits associated with tax deductions inexcess of recognized compensation cost to be reported as a financing cash flowrather than as an operating cash flow as currently required. We will adopt SFASNo. 123(R) on January 1, 2006. Upon adoption, we will use themodified prospective method and therefore will not restate our prior periodresults. SFAS No. 123(R) will apply to new share-based awards and tounvested stock options outstanding on the effective date and issuances underour employee stock purchase plan. Unrecognized non-cash stock compensationexpense related to unvested options outstanding as of December 31, 2005was approximately $26.9 million and will be recorded over the remaining vestingperiod of four years. We currently utilize the Black-Scholes optionpricing model to estimate the fair value for the pro forma net income andearnings per share calculations in Note 1 and will continue using the modelafter adoption of SFAS No. 123(R).

In May 2005, the FASBissued SFAS No. 154,*Accounting Changesand Error Corrections.* SFAS No. 154 requires retroactiveapplication of a voluntary change in accounting principle to prior periodfinancial statements unless it is impracticable. SFAS No. 154 alsorequires that a change in method of depreciation, amortization or depletion forlong-lived, non-financial assets be accounted for as a change in accountingestimate that is affected by a change in accounting principle. SFAS No. 154replaces APB Opinion No. 20,*AccountingChanges* and SFAS No. 3,*Reporting Accounting Changes in Interim Financial Statements.*SFAS No. 154is effective for fiscal years beginning after December 15, 2005. TheCompany does not expect the adoption of the provisions of SFAS No. 154 tohave a material impact on its results of operations or financial condition.

**Acquisitions**

We believe that our total solutions approach willpositively impact all of our revenue categories. This includes our products andmanaged services offerings, as well as product support, professional servicesand training. While we expect the expansion of these product and serviceofferings to originate primarily from internal development, our strategyincludes acquiring products, technologies and service capabilities that fitwithin our strategy and could potentially accelerate the timing of thecommercial introduction of such products and technologies.

In January 2004, we acquired Cobion. Cobionprovides content filtering and anti-spam technology that protects individualsand enterprises against unwanted Web content, spam, misuse of information andlost productivity. The purchase price was approximately $33 million incash plus the direct costs of acquisition. The Cobion product continues to besold on a stand-alone basis and through OEM relationships and is a component ofour integrated security appliance.

In August 2002, ISS KK, our Asia/Pacificsubsidiary, acquired a distributor in Singapore, TriSecurity Holdings Pte Ltd.(“TriSecurity”). TriSecurity was the sole distributor for ISS KK in southeastAsia, including India, and its business was almost exclusively focused on ISSsolutions. This acquisition provides our Asia-Pacific subsidiary direct supportcapabilities for their customers in Southeast Asia and allows ISS KK to expandits capabilities in this growing market. The consideration consisted of2,000 shares of ISS KK stock and approximately $1.2 million of cash. Goodwillof approximately $4.0 million related to the purchase was recorded. Duringthe first quarter of 2003, ISS KK amended the agreement and agreed to make paymentof 490 shares of ISS KK in each of the first quarters of 2004 and 2005,relating to annual contingent consideration payments under the 2002 purchaseagreement. Due to regulatory issues, the agreement was amended prior to the2004 payment to make the 2004 and 2005 payments in cash in lieu of shares. Additionalconsideration of $764,000 and $498,000 was paid in February 2005 and 2004,respectively, based on the fair market value of the 490 shares, and isreflected in goodwill.

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**Results of Operations**

Thefollowing table sets forth our consolidated historical operating information,as a percentage of total revenues, for the periods indicated:

| ** **                                                              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Consolidated Statements  of Operations Data:                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Product licenses and sales                                              |       |                                       | 44         | % |   |   | 43 | % |   |   | 44 | % |   |
| Subscriptions                                                           |       |                                       | 49         |   |   |   | 49 |   |   |   | 46 |   |   |
| Professional services                                                   |       |                                       | 7          |   |   |   | 8 |   |   |   | 10 |   |   |
| Total revenues                                                          |       |                                       | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenues:                                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Product licenses and sales                                              |       |                                       | 9          |   |   |   | 8 |   |   |   | 4 |   |   |
| Amortization of acquired technology                                     |       |                                       | 2          |   |   |   | 2 |   |   |   | 1 |   |   |
| Subscriptions and professional services                                 |       |                                       | 16         |   |   |   | 17 |   |   |   | 20 |   |   |
| Total cost of revenues                                                  |       |                                       | 27         |   |   |   | 27 |   |   |   | 25 |   |   |
| Research and  development                                               |       |                                       | 14         |   |   |   | 15 |   |   |   | 17 |   |   |
| Sales and  marketing                                                    |       |                                       | 33         |   |   |   | 35 |   |   |   | 36 |   |   |
| General and  administrative                                             |       |                                       | 9          |   |   |   | 9 |   |   |   | 9 |   |   |
| Amortization and  write-off of intangibles and stock based compensation |       |                                       | —     |   |   |   | — |   |   |   | 1 |   |   |
| Total costs and expenses                                                |       |                                       | 83         |   |   |   | 86 |   |   |   | 88 |   |   |
| Operating income                                                        |       |                                       | 17         | % |   |   | 14 | % |   |   | 12 | % |   |

 

**Revenues**

***Product licenses and sales***

Since the second quarter of 2003, we have offered theProventia family of network protection appliances that collectively providesunified, multi-function protection capabilities designed to identify andprevent many forms of attack with minimal user intervention. These products aredesigned to operate in demanding network environments while being easy todeploy, easy to use and centrally managed, all in an effort to make oursolution more cost-effective. The market response has been dramatic asProventia grew from 23% of product license and sales revenues in its year ofintroduction to 68% in 2005.

Product licenses and sales increased by 16% and 18% in2005 and 2004, respectively, due to this positive market response to ourProventia line, reversing a decreasing trend for the previous three years. Thisrevenue category increased slightly to 44% of total revenues in 2005 comparedto 43% in 2004 and 44% in 2003 as subscription revenues continued to growsignificantly.

Our future growth isdependent on a continuation of the positive market response to our Proventiafamily of products. Our present product roadmap also focuses on productofferings and enhancements that will continue to improve central control andmanageability, easier deployment and more refined information as well asbroader Proventia appliance offerings. We expect that this focus will continueto make our products more cost effective to implement and maintain the goal ofincreasing the future level of product licenses and sales. This expected growthis critical as it represents not only product and license revenues, but alsosubscription revenues from product support and content.

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***Subscriptions***

Subscription revenues consist of product support andcontent updates, security-monitoring fees for managed services offerings, andterm licenses of products. Subscriptions revenue represented 49% of totalrevenues in 2005 and 2004, and 46% of total revenues in 2003.

The largest component of subscription revenues,product content and support, increased to 32% of total revenues in 2005compared to 31% of total revenues in 2004 and 2003. Product content and supportincludes hardware support of our Proventia appliances, software updates andsoftware blades, technical support and security content that includes advisoryupdates from X-Force, our internal team of security experts. Product contentand support are provided to our customers through contracts executed withcustomers for a specified term and billed at the time of contract. Suchbillings are recorded as deferred revenues on our balance sheet and amortizedas subscriptions revenue over the term of the contract. We expect productcontent and support revenues to increase in the future as our client base thatgenerates product content and support revenues expands.

Managed services revenuesincreased to 14% of total revenues in 2005, as compared with 13% in 2004 and11% in 2003. We believe these increases were due to a strong demand in themarket for proven, financially sound, managed security service providers. We aremarketing managed services both directly to end users and through partners,including a number of new arrangements with integrators and service providersthat include managed services as a part of their service offerings to theircustomers. We also expect sales of managed services to continue to growsteadily as we focus our efforts on marketing offerings to new and existingcustomers that meet changing needs in today’s environment.

***Professional services***

Professional servicesrevenue decreased both in absolute dollars and as a percentage of total revenueto 7% in 2005 from 8% in 2004 and 10% in 2003. We continue to focus onhigh-value offerings that utilize our X-Force expertise, and look to our systemintegration and channel partners to serve as the primary resource to fulfillthe services and education needs of our customers.

***Geographic regions***

Geographically,we derived the majority of our revenues from sales to customers within theAmericas region. Revenues by region represented the following percentages oftotal revenues:

| ** **   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
| Americas     |       |     | 63         | %        |       |     | 64         | % |   |   | 69 | % |   |
| EMEA         |       |     | 22         | %        |       |     | 22         | % |   |   | 19 | % |   |
| Asia/Pacific |       |     | 15         | %        |       |     | 14         | % |   |   | 12 | % |   |

 

While there have beenchanges in the proportion of revenues generated by each region, all of theregions experienced growth in revenues in 2005. Revenues in EMEA benefited fromvolume growth. A strengthening Euro throughout 2004 and 2003 also helped EMEAresults, since products sold to EMEA customers are primarily sold in the Eurocurrency. Even with the weakening Euro in 2005, EMEA experienced revenue growthin Euros and U.S. dollars. The financial data for each segment can be found inNote 11 to the consolidated financial statements.

**Costs and Expenses**

***Personnel***

Personnel and related costs represent our largestexpense category. We ended 2005 with approximately 1,250 employees, up from1,200 at the beginning of the year. The majority of headcount 

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growth occurred inquota-carrying sales personnel, marketing, managed security servicesoperations, finance and human resources. Our headcount has fluctuated betweenapproximately 1,150 and 1,250 over the last 3 years as we acquired andintegrated acquisitions and continually refined our business targets in lightof economic conditions during these years.

We began to use restrictedstock, in addition to stock options, as an equity component of compensationbeginning in the first quarter of 2004. We recorded $2.1 million and$2.0 million of compensation expense in 2005 and 2004, respectively,associated with restricted stock in the expense categories in which therecipients are placed.

***Cost of product licenses and sales***

Cost of product licenses and sales consists of severalcomponents. Costs associated with licensing our software products are minor. Thesubstantial portion of our cost of product licenses and sales represents thehardware cost of our Proventia appliances. As a percentage of product licensesand sales revenues, these costs increased from 9% in 2003 to 18% in 2004 and20% in 2005. The increase is attributable to the dramatic increase in Proventiaappliance revenues in these periods. We also licensed development source codein 2004, which is being amortized as cost of products sold over its estimateduseful life of four years.

We also incurred$7.0 million in 2005, $6.9 million in 2004 and $4.4 million in2003 of amortization expense related to core and developed technology that wasrecorded as a result of acquisitions accounted for under the purchase method ofaccounting.

***Cost of subscriptions and professional services***

Cost of subscriptions and professional servicesincludes the cost of our technical support personnel who provide assistance tocustomers under product support agreements, the security operations center (“SOC”)costs of providing managed security monitoring services and the costs relatedto our professional services and training. These costs were $52.8 millionin 2005, $49.0 million in 2004 and $48.7 million in 2003. As apercentage of subscription and professional services revenues, these costsdecreased to 29% in 2005 from 30% in 2004 and 35% in 2003. The total dollarchange from 2005 compared to 2004 of $3.8 million is due primarily toincreased staffing levels in our managed security services group totaling $2.9million.

Costs associated with our technical support personneland our security operations centers increased each year in 2005, 2004 and 2003as we added personnel to handle additional customers. We gained efficiencies inour SOC’s and restructured our support groups to be more productive so personnelincreased at a much lower rate than revenue growth, contributing to thedecrease in those costs as a percentage of total revenues. Additionally, ourappliances typically require less technical support effort than our softwareproducts. While we continue to seek increased productivity, we do expect someincrease in costs with a continued increase in revenues in the future.

Offsetting this increasein costs associated with our technical support personnel and our SOC’s was adecrease in costs associated with our professional services and educationservices commensurate with the decrease in the associated revenues.

***Research and development***

Research and development expenses consist of salaryand related costs of research and development personnel, including costs foremployee benefits, and depreciation on computer equipment. These costs includethose associated with maintaining and expanding the X-Force, our internal teamof security experts. We believe our primary research and product developmentand managed service offerings are important to retaining our leadershipposition in the market. We continue to add functionality to our 

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product family, providinggateway, network, server and desktop-based solutions, as well as to oursecurity management applications. These improvements as well as new offeringsare intended to provide our customers with more powerful and easier-to-usesolutions for security management across the enterprise.**

Research and development expenses were$45.2 million in 2005, $43.0 million in 2004 and $41.8 millionin 2003. These costs decreased as a percentage of total revenues to 14% in 2005from 15% in 2004 and 17% in 2003. The increase in expense dollars in 2005 is aresult of additional consulting expenses as we continue to invest in our productofferings.

Throughout 2004 and 2003, we reorganized andconsolidated our efforts for security content, protection agent frameworks,management infrastructure and multifunction appliance delivery to enhanceoperational and development efficiency. This resulted in closing ourengineering operations in Reading, U.K. and Sydney, Australia in the fourthquarter of 2003. These exit costs, which totaled $1.5 million, increasedresearch and development expenses by 1% of total revenues in 2003. In 2004, wecontinued to streamline our operations as we relocated some engineeringfunctions from our California development facility to Atlanta and offshore. Wealso had expense increases in 2004 as a result of additions to our headcountdue to the Cobion acquisition in the first quarter of 2004 and continuedinvestment in our Proventia line.

We are committed tocontinue our investment in X-Force research and development capabilities, whichwe believe distinguishes ISS from its competitors. We intend to reinvest in theareas of research and development as we accelerate product cycles, enhancecurrent technologies and develop new technologies.

***Sales and marketing***

Sales and marketing expenses consist of salaries,travel expenses, commissions, advertising, maintenance of our website, tradeshow expenses, costs of recruiting sales and marketing personnel and costs ofmarketing materials. Sales and marketing expenses were $108.9 million in2005, $101.0 million in 2004 and $87.5 million in 2003.

In 2005 and 2004, sales and marketing expensesincreased in absolute dollars but decreased as a percentage of total revenuesto 33% in 2005 and 35% in 2004, down from 36% in 2003. We added quota-carryingheadcount in 2005 and 2004 and had higher variable commission expenseassociated with higher product license and sales revenues, but gained leveragefrom our sales force as we continued to increase the percentage of salesfulfilled through the channel.

We expect to continue toachieve leverage in our sales efforts by focusing our direct sales force onlarge customers that are served either directly by us or through large systemsintegrators. Our channel, which includes systems integrators, value-addedresellers and distributors, will continue to be of increasing importance to us,measured quantitatively by an increasing level of product revenue originatingthrough the channel. In 2005 the channel represented approximately 75% of oursales as compared to 68% in 2004 and 63% in 2003. We intend to use itscapabilities to reach larger customers through joint selling efforts and toreach departmental and small companies, especially for our Proventiamulti-function appliance, which we believe has much more appeal to thesecompanies.

***General and administrative***

General and administrative expenses of$30.2 million in 2005, $27.6 million in 2004 and $22.7 millionin 2003, represented approximately 9% of our total revenues in 2005, 9% in 2004and 9% in 2003. General and administrative expenses consist ofpersonnel-related costs for executive, administrative, finance and humanresources, internal information systems and other support services costs, andlegal, accounting and other professional service fees.

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In 2005, general and administrative expenses increasedprimarily due to additional legal fees and non-capitalized expenses related tothe implementation of Oracle ERP, offset by savings resulting from lower costsrelated to financial control compliance work required by Sarbanes Oxley Act Section 404.

The largest increase in2004 was approximately $2 million for outside resources to assist in the designand execution of control testing related to financial control compliance workrequired by Sarbanes Oxley Act Section 404 as well as the related auditcosts. Amortization of restricted stock, as previously discussed, was also anew expense item in 2004. 

***Amortization***

We incurred amortizationexpense of $167,000 in 2005, $402,000 in 2004 and $1.6 million in 2003. Amortizationconsists of acquisition related expense for amortization of acquiredintangibles and acquisition related compensation charges for unvested stockoptions. These intangible assets and stock-based compensation resulted fromacquisitions accounted for under the purchase method of accounting and areamortized over their expected lives. Due to the closing of our Reading, UK andSydney, Australia research and development facilities in late 2003, the expensein 2003 includes a $738,000 charge related to our workforce reductions at thesefacilities.

***Interest income***

Interest income increasedto $5.7 million in 2005 from $2.5 million in 2004 and$2.7 million in 2003. The increase in interest income from 2004 to 2005 isa result of higher yields on our investment-grade commercial paper and similarinvestments from approximately 1.1% in 2004 to 2.3% in 2005 and an increase inthe average investment balance of $13.3 million. While the market rate ofinterest did increase slightly in 2004 to 1.1% from 1.0% in 2003, interestincome decreased in 2004 due to a decrease in cash and cash equivalents as weutilized available cash for our stock repurchase program and the January 2004acquisition of Cobion.

***Other income (expense), net***

In 2005, other expense of$1.7 million consisted primarily of foreign exchange losses of $1.2 million,minority interest expense of $257,000 and a loss on the write-down of aninvestment made by our Asia/Pacific subsidiary of approximately $175,000. In2004, other expense of $866,000 consisted primarily of minority interestexpense of $637,000 and a write-down of an investment made by our Asia/Pacificsubsidiary of approximately $500,000, partially offset by foreign exchangegains. In 2003, other expense was primarily related to minority ownershipinvestments by our Japan subsidiary in a number of private companies, whichultimately produced a $2.2 million impairment loss in 2003.

***Provision for income taxes***

Our provision for incometaxes and effective tax rate was $22.4 million and 36.8% in 2005,$15.4 million and 36.9% in 2004, and $11.2 million and 36.3% in 2003.Taxes paid during 2003 and 2004 generally relate to foreign operations. Incometax expense was recorded on domestic income for each year but taxes payablewere reduced by deductions related to the value of employee exercise of stockoptions. The tax benefit for the use of these stock option deductions wasrecorded as additional paid-in capital.

**Liquidity and Capital Resources**

Our financial position remained strong throughout 2005.Our cash and cash equivalents at December 31, 2005 were $238.9 million. Wehad no investments in marketable securities at December 31, 2005, otherthan $2.1 million which was restricted and included in our “Restricted cash andmarketable securities” section of the balance sheet.

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During 2005, we met our working capital needs andcapital equipment needs with cash provided by operations. Cash provided byoperations in 2005 totaled $72.6 million compared to $65.0 million in 2004and $48.7 million in 2003. The major components of cash flows provided byoperating activities in 2005 were net income of $38.5 million, non-cashdepreciation and amortization changes of $20.1 million, an increase inaccounts payable and accrued expenses of $16.2 million, income tax benefit fromexercise of stock options of $4.3 million, a decrease in deferred revenues of $7.5million, offset by an increase in accounts receivable of $16.6 million, all netof foreign currency impact.

An important element of our liquidity is thecollection of our accounts receivable. These receivables totaled$87.8 million at December 31, 2005 and had increased by$12.4 million during 2005. We measure our accounts receivable managementby our daily sales outstanding. This is a measurement of accounts receivabledivided by billings in the quarterly period, represented by the sum of revenuesplus the change in the deferred revenues liability account balance. Thismeasurement was 82, 75 and 81 days at December 31, 2005, 2004 and2003, respectively, each within our publicly stated target range of 75 to85 days.

Our net cash provided by investing activities of $65.0 millionin 2005 resulted primarily from our proceeds from maturity and sales ofintermediate term marketable securities, primarily interest-bearing governmentobligations and commercial paper of $138.5 million versus purchases of $67.8million. Our purchases of property and equipment of $7.1 million consistedprimarily of upgrades of computer hardware to new and existing employees andinvestment in infrastructure hardware and software applications.

Our financing activities used $30.4 million ofcash in 2005, principally due to the repurchase of 2.3 million shares ofour common stock in the open market at an aggregate cost of $49.9 millionwhich was partially offset by proceeds from exercise of stock options of $18.8million. The previous stock repurchase plan expired in July 2005 and a newrepurchase program to repurchase up to $100.0 million of our common stockthrough July 2006 was authorized by the Board of Directors in July 2005.Since the inception of the stock repurchase programs, we have purchasedapproximately 7.1 million shares of our common stock on the open market atan average cost of approximately $17.50 per share for a total cash outlay ofapproximately $124.3 million. We can purchase up to an additional$68.4 million under the current program.

At December 31, 2005, we had $238.9 millionof cash and cash equivalents. An additional $8.6 million of cashequivalents and marketable securities are pledged as collateral for stand-byletters of credit related to the operating leases of our facilities and areshown on the balance sheet as restricted marketable securities and cashequivalents. We believe that such cash and cash equivalents and marketablesecurities will be sufficient to meet our working capital needs and capitalexpenditures for the foreseeable future. Furthermore, we are not aware of anytrends, events, or uncertainties that are reasonably likely to result in anysignificant change to our liquidity.

From time to time, weevaluate possible acquisition and investment opportunities in businesses,products or technologies that are complementary to ours. In the event wedetermine to pursue such opportunities, we may use our available cash and cashequivalents and marketable securities for this purpose.

***Off-Balance Sheet Arrangements***

Payments for certain ofour operating leases are secured by two collateralized stand-by letters ofcredit totaling approximately $7.3 million at December 31, 2005. Thestand-by letters of credit are annually renewable over the duration of theapplicable leases. These stand-by letters of credit guarantee our paymentobligations on the leases. If we default on the lease payments, the landlordscan claim against the letters of credit. We, in turn, would be liable to theletter of credit issuers. Our stand-by letters of credit are 

31

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collateralizedby cash and marketable securities worth $8.6 million at December 31,2005. Other than these non-cancelable operating leases, we have no off-balancesheet financing arrangements, any relationships with “structured finance” or “specialpurpose” entities, or any contractual obligations with unconsolidated entitiesthat are reasonably likely to impact our liquidity.

***Contractual Commitments***

Thefollowing table summarizes our significant contractual obligations at December 31,2005, and the effect such obligations are expected to have on our liquidity andcash flows in future periods. This table excludes amounts already recorded onour balance sheet as current liabilities at December 31, 2005 (amounts inthousands):

| ** **                   | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|------------------------------|------------|------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **Total**  | ** ** | **Less than  1 Year**           | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After  5 Years** | ** ** |
| Operating lease  obligations |       | $          | 66,115     |                                      |       | $ | 12,372 |   |   | $ | 18,972 |   | $ | 15,192 |   | $ | 19,579 |   |
|                              |            |            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The expected timing andpayment of the obligations above is estimated based on current information. Timingof payments and actual amounts paid may be different depending on the timing ofreceipt of goods or services or changes to agreed-upon amounts for someobligations.

**Item 7A.**                *Quantitative and Qualitative Disclosures About Market Risk*

**Interest Rate Sensitivity**

The primary objective ofour investment activities is to preserve principal while at the same timemaximizing the income we receive from our investments without significantlyincreasing risk. Prior to 2005, the Company maintained a portfolio of cashequivalents and marketable securities in a variety of high-quality relativelyshort-term investments, including government securities, commercial paper andovernight repurchase agreements, as well as longer term securities that haveinterest rates that are adjusted to market on a short-term basis. Some of thesesecurities in which we were invested may have been subject to market risk. Thismeans that a change in prevailing interest rates may have caused the principalamount of the investment to fluctuate. For example, if we held a security thatwas issued with a fixed interest rate at the then-prevailing rate and theprevailing interest rate later rises, the market value of our investment wouldprobably decline. During 2005, we modified our investment strategy to invest inshorter term investments due to the low yield differential between money marketrates and 90 to 180 day commercial paper. Therefore, as our existinginvestments mature, we are moving the proceeds to overnight repurchaseagreements. As of December 31, 2005, we had $491,000 of securitieswith fixed rates of interest that mature in more than three months and nosecurities with fixed rates of interest that mature in more than six months butless than one year. Based on the average investments outstanding during 2005and 2004, increases or decreases of 25 basis points would result in increasesor decreases to interest income of approximately $620,000 and $575,000 in 2005and 2004, respectively, from the reported interest income.

**RiskAssociated with Foreign Exchange Rates**

ISS is subject to foreign exchange risk as a result ofexposures to changes in currency exchange rates. Our foreign operations are,for the most part, naturally hedged against exchange rate fluctuations sincethe majority of revenues and expenses of each foreign affiliate are denominatedin the same currency. Therefore, we do not engage in formal hedging activities,but we do periodically review the potential impact of this risk to ensure thatthe risk of significant potential losses remains minimal. As a result, anunfavorable change in the exchange rate for any particular foreign subsidiarywould result in lower revenues and expenses with regards to operating results,and lower assets and liabilities with regards to the balance sheet.

32

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The Company’s operating results are affected bychanges in exchange rates between the U.S. Dollar and the Euro and theJapanese Yen. When the U.S. Dollar strengthens against these foreigncurrencies, the value of our reporting currency revenues decreases. When theU.S. Dollar weakens, the value of our reporting currency revenuesincreases. Since much of our international operating expenses are also incurredin local currencies, which is the foreign subsidiaries functional currency, theimpact of exchange rates on net income or loss is relatively less than theimpact on revenue. Although our operating and pricing strategies take intoaccount changes in exchange rates over time, our results of operations may beaffected significantly in the short term by fluctuations in foreign currencyexchange rates. A fluctuation of 10% in the average exchange rates of the Eurosand Japanese Yen relative to the US dollar during 2005, 2004 and 2003would have resulted in increases or decreases in operating income ofapproximately $5.4 million, $4.5 million and $2.6 million in2005, 2004 and 2003, respectively, from the reported operating income.

During 2005, the Company recorded a net foreignexchange loss of $1.2 million. The nature and extent of the foreign currencyrisk faced by the Company depends on many factors that cannot be accuratelypredicted. These factors include significant changes in foreign currency marketconditions, the Company’s inability to match foreign currency denominatedrevenues with costs denominated in the same currency, and changes in the amountor mix of revenues denominated in various foreign currencies. As a result ofmaterial unforeseen changes in these factors, the Company’s foreign currency riskcould have a greater impact on the Company’s results of operations in thefuture.

33

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**Item 8.**                        *Consolidated Financial Statements and Supplementary Data*
|                                                                                                                                                | ** ** | Page   |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|
| **Internet Security  Systems, Inc.**                                                                                                      |       |   |   |
| Report of Independent  Registered Public Accounting Firm Regarding Financial Statements                                                        |       | 40     |   |
| Consolidated Balance Sheets as of  December 31, 2005 and 2004                                                                             |       | 41     |   |
| Consolidated Statements of  Operations for the Years Ended December 31, 2005, 2004 and 2003                                               |       | 42     |   |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Income for the Years  Ended December 31, 2005, 2004 and 2003 |       | 43     |   |
| Consolidated Statements of  Cash Flows for the Years Ended December 31, 2005, 2004 and 2003                                               |       | 44     |   |
| Notes  to Consolidated Financial Statements                                                                                                    |       | 45     |   |
| Consolidated Financial  Statement Schedules                                                                                                    |       |   |   |
| Schedule II—Valuation and  Qualifying Accounts                                                                                       |       | 64     |   |

 

Schedules other than the one listed above are omittedas the required information is inapplicable or the information is presented inthe consolidated financial statements or related notes.

34

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**Item 9*.****                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure*

None.

**Item 9A*.****                Controls and Procedures*

**Disclosure Controls and Procedures**

ISS’ management, with the participation of the ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofour disclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as of December 31,2005. No system of controls, no matter how well designed and operated, canprovide absolute assurance that the objectives of the system of controls aremet, and no evaluation of controls can provide absolute assurance that thesystem of controls has operated effectively in all cases. Our disclosurecontrols and procedures however are designed to provide reasonable assurancethat the objectives of disclosure controls and procedures are met.

Based on such evaluation,these officers have concluded that, as of such date, our disclosure controlsand procedures were effective to provide reasonable assurance that informationrequired to be disclosed in the reports the Company files or submits under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedon a timely basis.

**ManagementReport on Internal Control Over Financial Reporting**

The management of ISS is responsible for establishingand maintaining adequate internal control over financial reporting, as suchterm is defined in Rules 13a-15(f) and 15d-15(f) promulgatedunder Securities Exchange Act of 1934, as amended. ISS’ internal control systemwas designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.

Internal control systems, no matter how well designed,have inherent limitations. Therefore, even those systems determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation, and may not prevent or detectmisstatements. In addition, projections of any evaluation of effectiveness tofuture periods are subject to risks that controls may become inadequate becauseof changes in conditions, individuals make errors in judgment, or individualsdo not comply with policies or procedures.

ISS’ management assessed the effectiveness of thecompany’s internal control over financial reporting as of December 31,2005. In making this assessment, it used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in*Internal Control—Integrated Framework.*Based on this assessment, ISS’ managementdetermined that as of December 31, 2005, ISS maintained effective internalcontrol over financial reporting.

ISS’ independentregistered public accounting firm, Ernst & Young LLP, has issued anaudit report on our assessment of the company’s internal control over financialreporting, which is included on the following page.

**Changesin Internal Control Over Financial Reporting**

There have not been anychanges in ISS’ internal control over financial reporting during the quarterended December 31, 2005 that have materially affected, or are reasonablylikely to materially affect, such controls.

35

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersInternet Security Systems, Inc.

We have audited management’s assessment, included inthe accompanying Management Report on Internal Control Over FinancialReporting, that Internet Security Systems, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (the COSOcriteria). Internet Security Systems, Inc.’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe 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, management’s assessment that InternetSecurity Systems, Inc. maintained effective internal control overfinancial reporting as of December 31, 2005, is fairly stated, in allmaterial respects, based on the COSO criteria. Also, in our opinion, InternetSecurity Systems, Inc. maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, basedon the COSO criteria.

36

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Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofInternet Security Systems, Inc. as of December 31, 2005 and 2004, andthe related consolidated statements of operations, stockholders’ equity andcomprehensive income, and cash flows for each of the three years in the periodended December 31, 2005 of Internet Security Systems, Inc. and ourreport dated March 6, 2006 expressed an unqualified opinion thereon.
|                  | /s/ ERNST & YOUNG LLP |   |
|------------------|--------------------------------|--------|
| Atlanta, Georgia |                           |
| March 6, 2006    |                           |

 

**Item 9B*.****               OtherInformation*

None.

**PART III**

**Item 10.**                 *Directors and Executive Officers of the Registrant*

**Directorsand Executive Officers**

See the Proxy Statementfor the Company’s 2006 Annual Meeting of Stockholders, under the headings“Proposal One: Election of Directors”, “Executive Officers”, and“Section 16(a) Beneficial Reporting Compliance”, which information isincorporated herein by reference.

**Codeof Conduct and Code of Ethics for Financial Professionals**

The Company has adopted aCode of Conduct and a Code of Ethics for Financial Professionals which apply toits Chief Executive Officer, Chief Financial Officer, and Principal AccountingOfficer. These documents are available on the “Investor Relations—CorporateGovernance” portion of our website at www.iss.net\Company. Any waiver oramendment to such Codes for the benefit of such officers will also be posted tosuch website.

**Item 11.**                 *Executive Compensation*

See the Proxy Statementfor the Company’s 2006 Annual Meeting of Stockholders, under the headings“Director Compensation” and “Executive Compensation”, which information isincorporated herein by reference.

**Item 12.**                 *Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters*

See the Proxy Statementfor the Company’s 2006 Annual Meeting of Stockholders, under the headings“Security Ownership of Management and Principal Stockholders” and “EquityCompensation Plans”, which information is incorporated herein by reference.

**Item 13.**                 *Certain Relationships and Related Transactions*

See the Proxy Statementfor the Company’s 2006 Annual Meeting of Stockholders, under the heading“Certain Relationships and Related Transactions”, which information is incorporatedherein by reference.

**Item 14.**                 *Principal Accountant Fees and Services*

See the Proxy Statementfor the Company’s 2006 Annual Meeting of Stockholders, under the headings“Independent Auditors” and “Fee Pre-Approved Policy”, which information isincorporated herein by reference.

37

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**PART IV**

**Item 15.**                 *Exhibits and Financial Statement Schedules*

(a)          Thefollowing documents are filed as part of this report:

1.                 *Consolidated Financial Statements.* SeeIndex to Financial Statements on page 27

2.                 *Financial Statement Schedules.* See Indexto Financial Statements on page 27

3.                 *Exhibits.* The exhibits to this AnnualReport on Form 10-K have been included only with the copy of thisAnnual Report on Form 10-K filed with the Securities and ExchangeCommission. Copies of individual exhibits will be furnished to stockholdersupon written request to the Company and payment of a reasonable fee.
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **Description   of Exhibit** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|
| 3.1              | —     | Restated Certificate of  Incorporation (filed as Exhibit 3.1 to the Company’s Quarterly Report on  Form 10-Q, dated November 14, 2000 and incorporated by reference  herein).                                                                                                                                                                                                                                                                                                      |
| 3.2              | —     | Bylaws (filed as  Exhibit 3.2 to the Company’s Registration Statement on Form S-1,  Registration No. 333-44529 (the “Form S-1”) and  incorporated by reference herein).                                                                                                                                                                                                                                                                                             |
| 3.3              | —     | Certificate of  Designations of Series A Junior Participating Preferred Stock dated  July 24, 2002 facility (filed as Exhibit 3.3 to the Company’s  Annual Report on Form 10-K, dated March 28, 2003 and  incorporated by reference herein).                                                                                                                                                                                                                             |
| 4.1              | —     | Specimen Common Stock  certificate (filed as Exhibit 4.3 to the Company’s Registration  Statement on Form S-8, Registration No. 333-100954,  dated November 1, 2002 and incorporated by reference herein).                                                                                                                                                                                                                                                                    |
| 4.2              | —     | Form of Rights  Certificate (filed as Exhibit 4.2 to the Company’s Current Report on  Form 8-K dated July 24, 2002 and incorporated by reference  herein).                                                                                                                                                                                                                                                                                                                    |
| 4.3              | —     | See Exhibits 3.1  and 3.2 for provisions of the Certificate of Incorporation and Bylaws of the  Company defining the rights of holders of the Company’s Common Stock.                                                                                                                                                                                                                                                                                                                        |
| 4.4+             | —     | 1999 Network ICE Stock  Option Plan (filed as Exhibit 4.1 to the Company’s Registration  Statement on Form S-8, Registration No. 333-62658 (the  “Form S-8”), filed on June 8, 2001 and incorporated by  reference herein).                                                                                                                                                                                                                                    |
| 4.5+             | —     | Restated 1995 Stock  Incentive Plan (as amended and restated as of May 23, 2001) (filed as  Exhibit 4.2 to the Form S-8 filed June 8, 2001 and  incorporated by reference herein). Form of Notice of Grant and Stock  Option Agreement and Form of Restricted Stock Issuance Agreement (filed  as Exhibits 99.1 and 99.2, respectively, to the Company’s Current Report  on Form 8-K, filed January 27, 2005 and incorporated by  reference herein). |
| 4.6+             | —     | Netrex, Inc. 1998  Stock Plan (filed as Exhibit 99.15 to the Company’s Registration  Statement on Form S-8, Registration Statement No. 333-89563,  filed October 22, 1999 and incorporated by reference herein).                                                                                                                                                                                                                                                         |
| 4.7+             | —     | vCIS, Inc. 2001  Stock Plan (filed as to Exhibit 4.1 to the Company’s Registration  Statement on Form S-8, Registration Statement No. 333-100954,  filed November 1, 2002 and incorporated by reference herein).                                                                                                                                                                                                                                                         |
| 4.8+             | —     | Internet Security  Systems, Inc. 2005 Stock Incentive Plan (incorporated by reference from  Appendix A to the Company’s Definitive Proxy Statement filed April 18,  2005, file number 000-23655).                                                                                                                                                                                                                                                                                            |
| 10.1             | —     | Stock Exchange Agreement dated December 9, 1997  (filed as Exhibit 10.4 to the Form S-1 and incorporated by  reference herein).                                                                                                                                                                                                                                                                                                                                                         |

38

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| 10.2                                                | — | Forms of Non-Employee Director  Compensation Agreement, Notice of Stock Option Grants and Stock Option  Agreement (filed as Exhibit 10.6 to the Form S-1 and  incorporated by reference herein).                                                                                                             |
|-----------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3                                                | — | Form of  Indemnification Agreement for directors and certain officers (filed as Exhibit 10.8  to the Form S-1 and incorporated by reference herein).                                                                                                                                                    |
| 10.4                                                | — | Lease for Atlanta  headquarters and research and development facility (filed as  Exhibit 10.10 to the Company’s Annual Report on Form 10-K,  dated March 30, 2000 and incorporated by reference herein).                                                                                           |
| 10.5(a)                                             | — | Amendments to Lease for  Atlanta headquarters facility (filed as Exhibit 10.5 to the Company’s  Annual Report on Form 10-K, dated March 28, 2003 and  incorporated by reference herein).                                                                                                           |
|         (b) |   | Third Amendment to Lease  Agreement made and entered into as of this February 23, 2004, by and  between Wells Operating Partnership, L.P. and the Company (filed as  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q,  filed May 10, 2004, and incorporated by reference herein). |
| 10.6                                                | — | Letter Agreement dated  August 18, 2000 with Lawrence Costanza (filed as Exhibit 10.14 to  the Company’s Annual Report on Form 10-K, dated March 30,  2001 and incorporated by reference herein).                                                                                             |
| 10.7                                                | — | Rights Agreement dated  July 18, 2002 with SunTrust Bank, as Rights Agent, regarding Preferred  Share Purchase Rights (filed as Exhibit 4.1 to the Company’s Current  Report on Form 8-K dated July 24, 2002 and incorporated by  reference herein).                                          |
| 10.8+                                               | — | Form of Retention  Agreement (filed as Exhibit 10.1 to the Company’s Quarterly Report on  Form 10-Q filed November 5, 2003 and incorporated by  reference herein).                                                                                                                            |
| 10.10+                                              |   | Form of Executive  Incentive Plan (filed as Exhibit 10.1 to the Company’s Current Report on  Form 8-K, filed February 3, 2005, and incorporated by reference  herein).                                                                                                                        |
| 11**                                                | — | Computation of Per Share  Earnings                                                                                                                                                                                                                                                                                     |
| 21.1*                                               | — | Subsidiaries of the  Company.                                                                                                                                                                                                                                                                                          |
| 23.1*                                               | — | Consent of  Ernst & Young LLP.                                                                                                                                                                                                                                                                                |
| 24.1*                                               | — | Power of Attorney,  pursuant to which amendments to this Annual Report on Form 10-K  may be filed, is included on the signature page contained in  Part IV of the Form 10-K.                                                                                                                       |
| 31.1*                                               | — | Certification of  principal executive officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                         |
| 31.2*                                               | — | Certification of  principal financial officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                         |
| 32.1*                                               | — | Certification Pursuant  to 18 U.S.C. Section 1350. as Adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                |
| 32.2*                                               | — | Certification Pursuant to 18 U.S.C.  Section 1350. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                |

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*                    Identifiesthose filed exhibits with this Form 10-K.

+                Managementcontract or compensatory plan

**             Data required bySFAS No. 128, “Earnings Per Share”, is provided in Note 4 to theconsolidated financial statements in this report.

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

The Board of Directors and StockholdersInternet Security Systems, Inc.

We have audited the accompanying consolidated balancesheets of Internet Security Systems, Inc. as of December 31, 2005 and2004, and the related consolidated statements of operations, stockholders’equity and comprehensive income, and cash flows for each of the three years inthe period ended December 31, 2005. Our audits also included the financialstatement schedule listed in the Index at Item 15(a). These financialstatements and schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andschedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Internet Security Systems, Inc. as of December 31, 2005and 2004, and the consolidated results of its operations and its cash flows foreach of the three years in the period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of InternetSecurity Systems, Inc.’s internal controls over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated March 6, 2006 expressed an unqualified opinion therein.

|  | /s/ ERNST &  YOUNG LLP |   |
|--|---------------------------------|--------|

 

Atlanta, GeorgiaMarch 6, 2006

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**INTERNETSECURITY SYSTEMS, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                            | ** ** | **December 31,** | ** **  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                                                                                            | ** ** | **2005**              | ** **  | **2004** | ** ** |
| **ASSETS**                                                                                                                                            |       |                  |        |   |   |
| Current assets:                                                                                                                                       |       |                  |        |   |   |
| Cash and cash equivalents                                                                                                                             |       | $                     | 238,893,000 |   | $ | 140,148,000 |   |
| Marketable securities                                                                                                                                 |       | —                |        | 70,901,000 |   |
| Accounts receivable, less  allowance for doubtful accounts of $3,574,000 in 2005 and $3,099,000  in 2004                                    |       | 87,769,000            |        | 75,353,000 |   |
| Inventory                                                                                                                                             |       | 4,208,000             |        | 2,506,000 |   |
| Prepaid expenses and  other current assets                                                                                                            |       | 10,305,000            |        | 12,728,000 |   |
| Total current assets                                                                                                                                  |       | 341,175,000           |        | 301,636,000 |   |
| Property and equipment:                                                                                                                               |       |                  |        |   |   |
| Computer equipment and  software                                                                                                                      |       | 58,360,000            |        | 52,412,000 |   |
| Office furniture and  equipment                                                                                                                       |       | 17,797,000            |        | 18,091,000 |   |
| Leasehold improvements                                                                                                                                |       | 20,948,000            |        | 21,098,000 |   |
|                                                                                                                                                  |       | 97,105,000            |        | 91,601,000 |   |
| Less accumulated  depreciation                                                                                                                        |       | 67,754,000            |        | 57,161,000 |   |
|                                                                                                                                                  |       | 29,351,000            |        | 34,440,000 |   |
| Restricted  marketable securities and cash equivalents                                                                                                |       | 8,600,000             |        | 10,300,000 |   |
| Goodwill, less  accumulated amortization of $27,381,000                                                                                               |       | 220,224,000           |        | 224,065,000 |   |
| Other intangible  assets, less accumulated amortization of $27,490,000 in 2005 and  $20,951,000 in 2004                                          |       | 10,913,000            |        | 19,763,000 |   |
| Other assets                                                                                                                                          |       | 8,381,000             |        | 8,698,000 |   |
| Total assets                                                                                                                                          |       | $                     | 618,644,000 |   | $ | 598,902,000 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                        |       |                  |        |   |   |
| Current liabilities:                                                                                                                                  |       |                  |        |   |   |
| Accounts payable                                                                                                                                      |       | $                     | 11,261,000  |   | $ | 6,911,000 |   |
| Accrued expenses                                                                                                                                      |       | 35,019,000            |        | 25,238,000 |   |
| Deferred revenues                                                                                                                                     |       | 74,577,000            |        | 70,246,000 |   |
| Total current liabilities                                                                                                                             |       | 120,857,000           |        | 102,395,000 |   |
| Long-term deferred  revenues                                                                                                                          |       | 7,067,000             |        | 8,432,000 |   |
| Other non-current  liabilities                                                                                                                        |       | 202,000               |        | 2,651,000 |   |
| Commitments and contingencies                                                                                                                         |       |                  |        |   |   |
| Minority interest                                                                                                                                     |       | 4,378,000             |        | 3,844,000 |   |
| Stockholders’ equity:                                                                                                                            |       |                  |        |   |   |
| Preferred stock;  $.001 par value; 20,000,000 shares authorized, none issued or  outstanding                                                |       | —                |        | — |   |
| Common stock;  $.001 par value; 120,000,000 shares authorized, 52,204,000 and  50,754,000 shares issued in 2005 and 2004, respectively |       | 52,000                |        | 51,000 |   |
| Additional paid-in  capital                                                                                                                           |       | 524,105,000           |        | 499,534,000 |   |
| Deferred  compensation                                                                                                                                |       | (1,830,000            | )           | (3,197,000 | ) |
| Accumulated other  comprehensive income                                                                                                               |       | 1,058,000             |        | 11,041,000 |   |
| Retained earnings                                                                                                                                     |       | 87,089,000            |        | 48,544,000 |   |
| Treasury stock, at  cost (7,129,000 and 4,871,000 shares in 2005 and  2004, respectively)                                                        |       | (124,334,000          | )           | (74,393,000 | ) |
| Total stockholders’  equity                                                                                                                      |       | 486,140,000           |        | 481,580,000 |   |
| Total liabilities and stockholders’ equity                                                                                                       |       | $                     | 618,644,000 |   | $ | 598,902,000 |   |

 

See accompanying notes.

41

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**INTERNETSECURITY SYSTEMS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                                    | ** ** | **Year Ended December 31,** | ** **  |
|-------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                    | ** ** | **2005**                                   | ** **  | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                                     |       |                                       |        |   |   |   |   |
| Product licenses and sales                                                    |       | $                                          | 146,347,000 |   | $ | 126,112,000 |   | $ | 107,117,000 |   |
| Subscriptions                                                                 |       | 161,101,000                                |        | 140,693,000 |   | 112,855,000 |   |
| Professional services                                                         |       | 22,324,000                                 |        | 23,088,000 |   | 25,809,000 |   |
|                                                                          |       | 329,772,000                                |        | 289,893,000 |   | 245,781,000 |   |
| Costs and  expenses:                                                          |       |                                       |        |   |   |   |   |
| Cost of revenues:                                                             |       |                                       |        |   |   |   |   |
| Product licenses and sales                                                    |       | 28,853,000                                 |        | 22,388,000 |   | 9,528,000 |   |
| Amortization of acquired technology                                           |       | 6,985,000                                  |        | 6,851,000 |   | 4,404,000 |   |
| Subscriptions and professional services                                       |       | 52,829,000                                 |        | 48,999,000 |   | 48,686,000 |   |
| Total cost of revenues                                                        |       | 88,667,000                                 |        | 78,238,000 |   | 62,618,000 |   |
| Research and development                                                      |       | 45,177,000                                 |        | 42,976,000 |   | 41,843,000 |   |
| Sales and marketing                                                           |       | 108,908,000                                |        | 100,966,000 |   | 87,452,000 |   |
| General and administrative                                                    |       | 30,182,000                                 |        | 27,568,000 |   | 22,661,000 |   |
| Amortization and write-off of other intangibles and  stock-based compensation |       | 167,000                                    |        | 402,000 |   | 1,611,000 |   |
|                                                                          |       | 273,101,000                                |        | 250,150,000 |   | 216,185,000 |   |
| Operating income                                                              |       | 56,671,000                                 |        | 39,743,000 |   | 29,596,000 |   |
| Interest income                                                               |       | 5,724,000                                  |        | 2,517,000 |   | 2,683,000 |   |
| Other income  (expense), net                                                  |       | (1,674,000                                 | )           | (866,000 | ) | (1,560,000 | ) |
| Gain on issuance  of subsidiary stock                                         |       | 220,000                                    |        | 292,000 |   | 249,000 |   |
| Income before income taxes                                                    |       | 60,941,000                                 |        | 41,686,000 |   | 30,968,000 |   |
| Provision for  income taxes                                                   |       | 22,396,000                                 |        | 15,393,000 |   | 11,231,000 |   |
| Net income                                                                    |       | $                                          | 38,545,000  |   | $ | 26,293,000 |   | $ | 19,737,000 |   |
| Basic net income per share of Common Stock                                    |       | $                                          | 0.86        |   | $ | 0.56 |   | $ | 0.40 |   |
| Diluted net income per share of Common Stock                                  |       | $                                          | 0.82        |   | $ | 0.54 |   | $ | 0.39 |   |
| Weighted average  shares and equivalent shares:                               |       |                                       |        |   |   |   |   |
| Basic                                                                         |       | 45,037,000                                 |        | 46,985,000 |   | 49,155,000 |   |
| Diluted                                                                       |       | 47,261,000                                 |        | 48,458,000 |   | 50,018,000 |   |

 

See accompanying notes.

42

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**INTERNET SECURITY SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITYAND COMPREHENSIVE INCOME**

| ** **                                                                                       | ** ** | ** **            | ** ** | **Additional** | ** ** | ** **   | ** ** | **Accumulated  Other** | ** ** | ** **   | ** ** | ** **   | ** ** | **Total**         | ** ** | **Total**              | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|------------------------|------------|--------------|------------|--------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                       | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Deferred** | ** ** | **Comprehensive**      | ** ** | **Retained** | ** ** | **Treasury** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                       | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **Compensation**       | ** ** | **Income**   | ** ** | **Earnings** | ** ** | **Stock**         | ** ** | **Income**             | ** ** | **Equity** | ** ** |
| Balance at  December 31, 2002                                                               |       | 49,544,000            |       |           | $          | 50,000       |       |                   | $          | 463,779,000  |       |         | $          | (702,000          | )          |                   |       | $ | 949,000 |   |   | $ | 2,514,000 |   | $ | (2,034,000 | ) |   |   |   |   |   | $ | 464,556,000 |   |   |
| Comprehensive income:                                                                            |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                       |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       | 19,737,000 |   |   |   |   | $ | 19,737,000 |   |   |   | 19,737,000 |   |   |
| Translation adjustment                                                                           |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              | 6,503,000  |                   |       |   |   |   |   |   | 6,503,000 |   |   |   | 6,503,000 |   |   |
|                                                                                             |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   | $ | 26,240,000 |   |   |   |   |   |   |
| Issuance of Common Stock:                                                                        |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock options                                                                        |       | 133,000               |       |           |       |         |       | 1,011,000              |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 1,011,000 |   |   |
| Employee stock purchase  plan                                                                    |       | 152,000               |       |           |       |         |       | 1,609,000              |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 1,609,000 |   |   |
| Restricted stock awards                                                                          |       | 13,000                |       |           |       |         |       | 213,000                |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 213,000 |   |   |
| Amortization of deferred  compensation                                                           |       |                  |       |           |       |         |       |                   |       |         | 359,000    |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 359,000 |   |   |
| Deferred acquisition  payment                                                                    |       |                  |       |           |       |         |       | 625,000                |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 625,000 |   |   |
| Adjustment to deferred  compensation and repurchase of unvested shares from terminated employees |       | (1,000                | )          |           |       |         |       | (252,000               | )          |         | 251,000    |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | (1,000 | ) |   |
| Tax benefit related to  employee options                                                         |       |                  |       |           |       |         |       | 8,077,000              |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 8,077,000 |   |   |
| Purchases of treasury  stock (1,177,000 shares)                                             |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   | (16,346,000 | ) |   |   |   |   |   | (16,346,000 | ) |   |
| Balance at  December 31, 2003                                                               |       | 49,841,000            |       |           | 50,000     |         |       | 475,062,000            |       |         | (92,000    | )            |       |              | 7,452,000  |                   |       | 22,251,000 |   | (18,380,000 | ) |   |   |   |   |   | 486,343,000 |   |   |
| Comprehensive income:                                                                            |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                       |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       | 26,293,000 |   |   |   |   | $ | 26,293,000 |   |   |   | 26,293,000 |   |   |
| Translation adjustment                                                                           |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              | 3,589,000  |                   |       |   |   |   |   |   | 3,589,000 |   |   |   | 3,589,000 |   |   |
|                                                                                             |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   | $ | 29,882,000 |   |   |   |   |   |   |
| Issuance of Common Stock:                                                                        |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock options                                                                        |       | 488,000               |       |           | 1,000      |         |       | 5,895,000              |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 5,896,000 |   |   |
| Employee stock purchase  plan                                                                    |       | 126,000               |       |           |       |         |       | 1,417,000              |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 1,417,000 |   |   |
| Restricted stock awards                                                                          |       | 316,000               |       |           |       |         |       | 5,514,000              |       |         | (5,514,000 | )            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | — |   |   |
| Amortization of deferred  compensation                                                           |       |                  |       |           |       |         |       |                   |       |         | 2,019,000  |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 2,019,000 |   |   |
| Deferred acquisition  payment                                                                    |       |                  |       |           |       |         |       | (625,000               | )          |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | (625,000 | ) |   |
| Adjustment to deferred  compensation and repurchase of unvested shares from terminated employees |       | (17,000               | )          |           |       |         |       | (312,000               | )          |         | 390,000    |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 78,000 |   |   |
| Tax benefit related to  employee options                                                         |       |                  |       |           |       |         |       | 12,583,000             |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 12,583,000 |   |   |
| Purchases of treasury  stock (3,561,000 shares)                                             |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   | (56,013,000 | ) |   |   |   |   |   | (56,013,000 | ) |   |
| Balance at  December 31, 2004                                                               |       | 50,754,000            |       |           | 51,000     |         |       | 499,534,000            |       |         | (3,197,000 | )            |       |              | 11,041,000 |                   |       | 48,544,000 |   | (74,393,000 | ) |   |   |   |   |   | 481,580,000 |   |   |
| Comprehensive income:                                                                            |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                       |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       | 38,545,000 |   |   |   |   | $ | 38,545,000 |   |   |   | 38,545,000 |   |   |
| Translation adjustment                                                                           |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              | (9,983,000 | )                      |       |   |   |   |   |   | (9,983,000 | ) |   |   | (9,983,000 | ) |   |
|                                                                                             |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   | $ | 28,562,000 |   |   |   |   |   |   |
| Issuance of Common Stock:                                                                        |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock options                                                                        |       | 1,371,000             |       |           | 1,000      |         |       | 18,792,000             |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 18,793,000 |   |   |
| Employee stock purchase plan                                                                     |       | 56,000                |       |           |       |         |       | 732,000                |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 732,000 |   |   |
| Restricted stock awards                                                                          |       | 56,000                |       |           |       |         |       | 1,286,000              |       |         | (1,286,000 | )            |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | — |   |   |
| Amortization of deferred  compensation                                                           |       |                  |       |           |       |         |       |                   |       |         | 2,107,000  |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 2,107,000 |   |   |
| Adjustment to deferred  compensation                                                             |       | (33,000               | )          |           |       |         |       | (546,000               | )          |         | 546,000    |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | — |   |   |
| Tax benefit related to  employee options                                                         |       |                  |       |           |       |         |       | 4,307,000              |       |         |       |         |       |              |       |                   |       |   |   |   |   |   |   |   |   |   | 4,307,000 |   |   |
| Purchases of treasury  stock (2,258,000 shares)                                             |       |                  |       |           |       |         |       |                   |       |         |       |         |       |              |       |                   |       |   |   | (49,941,000 | ) |   |   |   |   |   | (49,941,000 | ) |   |
| Balance at  December 31, 2005                                                               |       | 52,204,000            |       |           | $          | 52,000       |       |                   | $          | 524,105,000  |       |         | $          | (1,830,000        | )          |                   |       | $ | 1,058,000 |   |   | $ | 87,089,000 |   | $ | (124,334,000 | ) |   |   |   |   |   | $ | 486,140,000 |   |   |

 

See accompanying notes.

43

 

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**INTERNETSECURITY SYSTEMS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** **  |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                         | ** ** | **2005**                                   | ** **  | **2004** | ** ** | **2003** | ** ** |
| **Operating activities**                                                           |       |                                       |        |   |   |   |   |
| Net income                                                                         |       | $                                          | 38,545,000  |   | $ | 26,293,000 |   | $ | 19,737,000 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |                                       |        |   |   |   |   |
| Depreciation                                                                       |       | 12,903,000                                 |        | 16,252,000 |   | 13,114,000 |   |
| Amortization and  write-off of intangibles and stock-based compensation            |       | 7,152,000                                  |        | 7,253,000 |   | 6,015,000 |   |
| Accretion of discount on  marketable securities                                    |       | 245,000                                    |        | (33,000 | ) | 276,000 |   |
| Deferred compensation  expense                                                     |       | 2,107,000                                  |        | 2,019,000 |   | 124,000 |   |
| Minority interest                                                                  |       | 257,000                                    |        | 637,000 |   | 157,000 |   |
| Income tax benefit from  exercise of stock options                                 |       | 4,307,000                                  |        | 12,583,000 |   | 8,077,000 |   |
| Impairment of investment                                                           |       | 175,000                                    |        | 498,000 |   | 2,230,000 |   |
| Loss on disposal of  assets                                                        |       | 62,000                                     |        | 94,000 |   | — |   |
| Gain on issuance of  subsidiary stock                                              |       | (220,000                                   | )           | (292,000 | ) | (249,000 | ) |
| Changes in assets and liabilities, excluding the  effects of acquisitions:         |       |                                       |        |   |   |   |   |
| Accounts receivable                                                                |       | (16,632,000                                | )           | (8,003,000 | ) | (9,888,000 | ) |
| Inventory                                                                          |       | (1,696,000                                 | )           | (1,756,000 | ) | 305,000 |   |
| Prepaid expenses and  other assets                                                 |       | 1,674,000                                  |        | (5,749,000 | ) | (3,863,000 | ) |
| Accounts payable and  accrued expenses                                             |       | 16,208,000                                 |        | 115,000 |   | 7,100,000 |   |
| Deferred revenues                                                                  |       | 7,519,000                                  |        | 15,064,000 |   | 5,542,000 |   |
| Net cash provided by  operating activities                                         |       | 72,606,000                                 |        | 64,975,000 |   | 48,677,000 |   |
| **Investing activities**                                                           |       |                                       |        |   |   |   |   |
| Acquisitions, net of cash  received                                                |       | (764,000                                   | )           | (33,247,000 | ) | — |   |
| Purchases of marketable  securities                                                |       | (67,794,000                                | )           | (87,685,000 | ) | (76,493,000 | ) |
| Net proceeds from  maturity of marketable securities                               |       | 108,700,000                                |        | 62,767,000 |   | 84,267,000 |   |
| Net proceeds from sale of  marketable securities                                   |       | 29,750,000                                 |        | — |   | — |   |
| (Additions to) release of  restricted cash and marketable securities               |       | 1,700,000                                  |        | 2,460,000 |   | 1,930,000 |   |
| Purchases of property and  equipment                                               |       | (7,105,000                                 | )           | (14,502,000 | ) | (7,212,000 | ) |
| Net proceeds from  issuance of subsidiary stock                                    |       | 500,000                                    |        | 453,000 |   | 376,000 |   |
| Net cash provided by  (used in) investing activities                               |       | 64,987,000                                 |        | (69,754,000 | ) | 2,868,000 |   |
| **Financing activities**                                                           |       |                                       |        |   |   |   |   |
| Proceeds from exercise of  stock options                                           |       | 18,793,000                                 |        | 5,896,000 |   | 1,008,000 |   |
| Proceeds from issuance of  common stock                                            |       | 732,000                                    |        | 1,417,000 |   | 1,609,000 |   |
| Purchases of treasury  stock                                                       |       | (49,941,000                                | )           | (56,013,000 | ) | (16,346,000 | ) |
| Net cash used in  financing activities                                             |       | (30,416,000                                | )           | (48,700,000 | ) | (13,729,000 | ) |
| Foreign currency impact  on cash                                                   |       | (8,432,000                                 | )           | 1,396,000 |   | 6,098,000 |   |
| Net increase (decrease)  in cash and cash equivalents                              |       | 98,745,000                                 |        | (52,083,000 | ) | 43,914,000 |   |
| Cash and cash equivalents  at beginning of year                                    |       | 140,148,000                                |        | 192,231,000 |   | 148,317,000 |   |
| Cash and cash equivalents  at end of year                                          |       | $                                          | 238,893,000 |   | $ | 140,148,000 |   | $ | 192,231,000 |   |
| **Supplemental cash flow disclosure**                                              |       |                                       |        |   |   |   |   |
| Income taxes paid                                                                  |       | $                                          | 7,569,000   |   | $ | 4,126,000 |   | $ | 2,041,000 |   |

 

See accompanying notes.

44

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**INTERNET SECURITY SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2005**

**1.   SIGNIFICANTACCOUNTING POLICIES**

**Description of Business**

The business of InternetSecurity Systems, Inc. and its subsidiaries (“ISS” or “the Company”) is toserve as the trusted security expert to global enterprises and worldgovernments, providing software, appliances and services that protect ITinfrastructures against Internet threats. These threat protection solutions gobeyond basic access control to deliver multiple layers of defense that detect,prevent and respond to threats prior to those threats causing damage tobusiness operations.

**Principles of Consolidation**

The consolidated financial statements include theaccounts of Internet Security Systems, Inc. and its majority-ownedsubsidiaries. All significant intercompany and investment accounts andtransactions have been eliminated in consolidation. Certain prior year amountshave been reclassified to conform to current year presentation.

ISS’ shares are traded onthe NASDAQ National Market under the ticker symbol “ISSX”. In addition, ISS hasvarious other subsidiaries in the Americas, Europe and the Asia/Pacific regionswith primary marketing and sales responsibilities for ISS’ products andservices in their respective markets. ISS is organized as, and operates in, asingle business segment that provides products, technical support, managedsecurity services, professional security services and education services ascomponents of providing security management solutions. ISS is organized aroundgeographic areas: the Americas (United States, Canada, South America and LatinAmerica), EMEA (Europe, Middle East and Africa) and Asia/Pacific. Thesegeographic areas represent ISS’ three reportable segments (see Note 11).

**Foreign Currency Translations**

The functional currency ofISS’ foreign subsidiaries is the local currency. Assets and liabilitiesdenominated in foreign currencies are translated using the exchange rate on thebalance sheet dates. The translation adjustments resulting from this processare shown separately as a component of stockholders’ equity. Revenues andexpenses are translated using average exchange rates for the period.Transaction gains and losses are included in the results of operations.

**Use of Estimates**

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying notes. Actualresults will differ from those estimates, and such differences may be materialto the consolidated financial statements.

**Revenue recognition**

Revenue isrecognized in the following categories:

·       *Product licenses and sales,* which includerevenue from sales of perpetual software licenses and products;

45

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·       *Subscription revenues,* which consists ofcustomer support, including content updates and technical support, termlicenses, subscription licenses and managed service arrangements; and

·       *Professional services revenues,* whichincludes fee-based service engagements and training.

We recognizesoftware license revenue under the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) 97-2,*Software Revenue Recognition,* as modifiedby SOP 98-9,*Software RevenueRecognition with Respect to Certain Transactions,* when the followingcriteria have been met:

·       persuasiveevidence of an arrangement exists;

·       deliveryhas occurred or services have been rendered;

·       priceis fixed or determinable; and

·       collection is probable.

*Product licensesand sales*

We recognize perpetual software license revenues,assuming all other revenue recognition criteria are met, upon (1) deliveryof the software and (2) issuance of the related license, assuming that nosignificant vendor obligations or customer acceptance rights exist. Wherepayment terms are extended, revenue is recognized as such amounts become dueand payable. Revenue is also deferred when sales are deemed either not to befixed or determinable or collection is not probable based on evaluation of allterms of the transaction.

Product sales consist primarily of appliances sold inconjunction with ISS licensed software. These sales are recognized uponshipment to the customer provided all other revenue recognition criteria forsoftware license revenue recognition are met.

Sales of products aregenerated both through direct sales to end-users as well as through variouspartners, including system integrators, value-added resellers and distributors.Revenue from product licenses and sales is recognized when the sale hasoccurred for an identified end user, provided all other revenue recognitioncriteria are met. At the point of delivery, the customer has no right of return.We offer evaluation software available via download from our website andevaluation units for appliance-based products that allow potential customers tosee the functionality of the products on their own networks prior to purchase. 

*Subscriptionrevenues*

Subscription revenues consist of renewable customersupport, term licenses and security monitoring and management services. Renewablecustomer support is a separate element of sales of perpetual software licensesand products. Term licenses allow customers to use our products and receiveproduct support coverage and content updates for a specified period, generallytwelve months. We generally invoice for customer support and term licenses atthe beginning of the term and recognize revenue ratably over the subscriptionterm. Security monitoring and management services for information assets andsystems are part of managed services and associated revenues are recognized assuch services are rendered.

Historically, our softwareand intrusion prevention appliance sales have been accounted for primarily asrevenue at the time of sale, with product support and content updates generallyrepresenting between 20% and 30% of the related license or product amount. Priorto the second quarter of 2005, the majority of the initial price paid by thecustomer for certain Proventia integrated security appliance models was forselected content blades (sometimes referred to as “blades”), which customersacquire for a specified term that is recognized over such term as subscriptionrevenue. During the second quarter of 2005, we changed the pricing model forour Proventia integrated security appliances to our historical model underwhich 

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customersacquire the appliance bundled with most content blades, which are recorded asproduct revenue at the time of sale, and pay annual customer support fees at anaverage rate of 22% of the related product price. This change did not have amaterial impact on our results.

*Professionalservices revenues*

Service engagements aretypically billed on either a fixed fee or time-and-materials basis andprimarily consist of security assessments of customer networks and thedevelopment of customers’ security policies. These offerings are intended tosupport our goal of providing products and managed services. We prefer to haveour partners provide these services where practical. We recognize suchprofessional services revenues as the related services are rendered.

*Multiple elementsarrangements*

Our sales ofproduct and/or software licenses are multiple element arrangements that includeproduct support and content updates and may include other subscription orprofessional services delivered after the product or software license. Revenueis generally recognizable before delivery of every element of the arrangementwhen all of the following requirements exist:

·       vendorspecific objective evidence (“VSOE”) of fair value exists for the undeliveredelements;

·       thefunctionality of the delivered elements is not dependent on the undeliveredelements; and

·       deliveryof the delivered elements represents the culmination of the earnings process.

We recognize thedifference between the total arrangement fee and the amount deferred for theundelivered elements as revenues by allocating revenue to the deliveredproducts, licenses and services using the residual method. Under theresidual method, we allocate discounts inherent in the arrangement to productsand customer support updates associated with products that are initiallydelivered and recognize the other elements as they are delivered based on theVSOE of fair value, which is determined based on transactions where the companysells those elements separately. We determine fair value of the undeliveredelements based on historical evidence of our stand-alone sales of theseelements to third parties.

**Cost of Revenues**

Cost of revenues includesthe cost of product licenses and sales, amortization of acquired technology andthe cost of subscriptions and professional services. Cost of product licensesand sales includes the costs associated with licensing software and thehardware cost and shipping costs associated with appliances. These costs areincurred upon recognition of the associated product revenues. Cost ofsubscriptions and professional services includes the cost of the technicalsupport group that provides assistance to customers with product supportagreements, the operations center costs of providing managed services and thecosts related to the professional services and training staff.

**Cash and Cash Equivalents**

Cash equivalents includeall highly liquid investments with original maturities of three months or lesswhen purchased. Such amounts are stated at cost, which approximates marketvalue.

**Marketable Securities**

Marketable securitiesconsist of debt instruments of U.S. government agencies, state andmunicipal obligations, corporate commercial paper and other similar debtobligations. All such marketable securities have a maturity of less than twelvemonths. These investments are classified as available-for-sale and 

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reportedat fair market value. Unrealized gains and losses on available-for-salesecurities were immaterial for 2005 and 2004. Realized gains and losses, anddeclines in value judged to be other-than-temporary are included in netsecurities gains (losses) and are included in results of operations. Theamortization of the premium and discount arising at acquisition is included ininterest income (see Note 3).

**Concentrationsof Credit and Supplier Risk**

The Company operates in the software industry, whichis highly competitive and rapidly changing. Significant technological changesin the industry or customer requirements, or the emergence of competitiveproducts with new technologies or capabilities could adversely affect operatingresults. In addition, fluctuations of the U.S. dollar against foreigncurrencies or changes in local regulatory or economic conditions couldadversely affect operating results.

We carry little inventory of our appliance productsand we rely on suppliers to deliver necessary components to our contract manufacturersin a timely manner based on the forecasts we provide. We currently purchasesome Proventia appliance components and contract manufacturing services fromsingle or limited sources.

Financial instruments that potentially subject ISS tosignificant concentrations of credit risk consist principally of cash and cashequivalents, marketable securities and accounts receivable. ISS maintains cashand cash equivalents in short-term money market accounts with high qualityfinancial institutions and in short-term, investment grade commercial paper. Marketablesecurities consist of debt instruments of U.S. government agencies, stateand municipal obligations, corporate commercial paper and other similar debtobligations. Deposits held with banks may exceed the amount of insuranceprovided on such deposits. Generally, these deposits may be redeemed upondemand and therefore bear minimal risk.

ISS’ sales are global,primarily to companies located in the Americas, Europe, and the Asia/Pacificregions. ISS performs periodic credit evaluations of its customer’s financialcondition and does not require collateral. Accounts receivable are dueprincipally from large U.S. companies under stated contract terms. ISSalso has receivables from its European and Asia/Pacific operations, which areprincipally from its partners in such regions. This includes various marketssuch as China and Korea, where difficulties associated with doing businessexposes the Company to associated credit risk. ISS provides an allowance for uncollectibleaccounts for estimated credit losses as such losses become probable.

**Fair Value of Financial Instruments**

The carrying amountsreported in the balance sheets for cash and cash equivalents, marketablesecurities, accounts receivable and accounts payable are recorded at fair valueor approximate their fair values because of their current classifications.

**Property and Equipment**

Property and equipment arestated at cost less accumulated depreciation. Depreciation is computed usingthe straight-line method for financial reporting purposes on the basis of thefollowing estimated useful lives: three years for computer equipment andsoftware, five to seven years for office furniture and equipment and over theshorter of the estimated useful life or the term of the lease for leaseholdimprovements.

**Inventory**

Inventory consists offinished goods purchased for resale and evaluation units at customer sites andis recorded at the lower of cost or market. Cost is determined using thefirst-in, first-out (FIFO) method.

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**Goodwill and Intangibles**

Goodwill represents the excess acquisition cost overthe fair value of net assets acquired. Under Statement of Financial AccountingStandards (“SFAS”) No. 142,*Goodwilland Other Intangible Assets* goodwill is no longer amortized but issubject to annual impairment tests (or more frequent tests if impairmentindicators arise). The Company performed impairment tests of goodwill asrequired, evaluating recoverability based on a combination of forecasteddiscounted cash flows and stock market valuation. Goodwill was determined notto be impaired in 2005 or 2004 based on such tests.

Goodwilland intangible assets are comprised of the following, as of the datesindicated:

| ** **                    | ** ** | **December 31,** | ** **  |
|-------------------------------|------------|-----------------------|-------------|
| ** **                    | ** ** | **2005**              | ** **  | **2004** | ** ** |
| ** **                    | ** ** | **Gross**             | ** **  | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **Carrying**          | ** **  | **Accumulated** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amount**            | ** **  | **Amortization** | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Goodwill                      |       | $                     | 247,605,000 |   | $ | (27,381,000 | ) | $ | 251,446,000 |   | $ | (27,381,000 | ) |
| Amortized  intangible assets: |       |                  |        |   |   |   |   |   |   |
| Core technology               |       | $                     | 3,853,000   |   | $ | (3,483,000 | ) | $ | 3,853,000 |   | $ | (3,002,000 | ) |
| Developed technology          |       | 32,537,000            |        | (22,158,000 | ) | 34,775,000 |   | (16,235,000 | ) |
| Customer relationships        |       | 2,013,000             |        | (1,849,000 | ) | 2,086,000 |   | (1,714,000 | ) |
| Total                         |       | $                     | 38,403,000  |   | $ | (27,490,000 | ) | $ | 40,714,000 |   | $ | (20,951,000 | ) |

 

The change in the carrying amount of goodwill anddeveloped technology from December 31, 2004 to December 31, 2005 wasthe result of a purchase price adjustment related to the Cobion acquisition,currency translation adjustments, and additional consideration related to the2002 TriSecurity acquisition.

TheCompany amortizes intangible assets over their estimated useful lives of eightyears for core technology, five years for developed technology, and and threeto six years for work force and three years for customer relationships. Amortizationrelated to core technology and developed technology is classified as acomponent of cost of revenues. Amortization expense of intangible assets is asfollows:

| ** **             | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------|------------|----------------------------------------|------------|
| ** **             | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Core technology        |       | $                                      | 481,000    |   | $ | 481,000 |   | $ | 481,000 |   |
| Developed  technology  |       | 6,504,000                              |       | 6,370,000 |   | 3,923,000 |   |
| Work force             |       | —                                 |       | — |   | 426,000 |   |
| Customer relationships |       | 167,000                                |       | 324,000 |   | 88,000 |   |
|                        |            |                                        |            |  |  |  |  |  |  |  |

 

In 2003, as part of the closing of the UK and Sydneyresearch and development facilities as described in Note 13, the Companywrote-off the unamortized balances in the related work force intangiblestotaling $738,000.

The Company amortized $1.5 million in 2005 and2004 relating to the purchase of a software license used in certain of itsproducts. These costs are included in cost of product licenses and sales.

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Theestimated future amortization expense of intangible assets as of December 31,2005 is as follows:

| ** **   | ** ** | **Amount** | ** ** |
|--------------|------------|------------|------------|
| Fiscal year: |       |       |       |
| 2006         |       | $          | 4,906,000  |   |
| 2007         |       | 2,965,000  |       |
| 2008         |       | 2,959,000  |       |
| 2009         |       | 83,000     |       |
| Total        |       | $          | 10,913,000 |   |

 

The estimated netrealizable value of the core and developed technology is based on the estimatedundiscounted future net cash flows of the related products. Our assumptionsabout future revenues and expenses require significant judgment associated withthe forecasting of our product sales. As of December 31, 2005, theestimated undiscounted future cash flows expected from core and developedtechnology from acquisitions is sufficient to recover the carrying amounts ofthe related assets. If our customers do not ultimately accept these products,and there is no alternative future use for this technology, we could determinethat some or all of the remaining $10.9 million carrying value is impaired.In the event of impairment we would record an impairment charge that could havea material adverse effect on our results of operations.

**Income Taxes**

The provision for incometaxes is computed using the asset and liability method. Under this method, werecognize deferred tax assets and liabilities for the expected future taxconsequences of temporary differences between the financial statement carryingamounts and the tax bases of existing assets and liabilities, net operatingloss carryforwards and tax credit carryforwards. Deferred tax assets arereduced by a valuation allowance when it is more likely than not that someportion or all of the deferred tax assets will not be realized. We also accountfor any income tax contingencies in accordance with SFAS No. 5, *Accounting for Contingencies.*

**Research and Development Costs**

Research and developmentcosts are charged to expense as incurred. ISS has not capitalized any suchdevelopment costs under SFAS No. 86,*Accounting for the Costs of Computer Software to Be Sold, Leased, or OtherwiseMarketed,* because the costs incurred between the attainment oftechnological feasibility for the related software product through the datewhen the product is available for general release to customers has beeninsignificant.

**Advertising Costs**

ISS incurred advertisingcosts of $2,947,000 in 2005, $3,849,000 in 2004 and $3,477,000 in 2003, whichare expensed as incurred and are included in sales and marketing expense in thestatements of operations.

**Stock-Based Compensation**

SFAS No. 123,*Accounting for Stock-Based Compensation*, as amended by SFAS No. 148,*Accounting for Stock-Based Compensation—Transitionand Disclosure,* establishes accounting and reporting standards forstock-based employee compensation plans. As permitted by SFAS No. 123,ISS continues to account for stock-based compensation in accordance withAccounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees* (“APB 25”),and has elected the pro forma disclosure alternative of SFAS No. 123.

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Inaccordance with the pro forma disclosure alternative of SFAS No. 123 thefollowing table shows pro forma net income (loss) and pro forma net income(loss) per share for the periods indicated as if the Company had adopted SFASNo.123. The pro forma impact of applying SFAS No. 123 as illustrated belowwill not necessarily be representative of the pro forma impact in future years.Pro forma information is as follows:

| ** **                                                                                              | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income as  reported                                                                                 |       | $                                           | 38,545,000 |   | $ | 26,293,000 |   | $ | 19,737,000 |   |
| Add: stock-based  compensation included in reported net income, net of income taxes                     |       | 1,329,000                                   |       | 1,319,000 |   | — |   |
| Less: Stock-based  compensation expense computed under the fair value method, net of income  taxes |       | (13,098,000                                 | )          | (26,933,000 | ) | (28,099,000 | ) |
| Pro forma net income (loss)                                                                             |       | $                                           | 26,776,000 |   | $ | 679,000 |   | $ | (8,362,000 | ) |
| Basic net income per share of Common Stock, as  reported                                                |       | $                                           | 0.86       |   | $ | 0.56 |   | $ | 0.40 |   |
| Diluted net income per share of Common Stock,  as reported                                              |       | $                                           | 0.82       |   | $ | 0.54 |   | $ | 0.39 |   |
| Pro forma basic net income (loss) per share of  Common Stock and equivalents                            |       | $                                           | 0. 59      |   | $ | 0.01 |   | $ | (0.17 | ) |
| Pro forma diluted net  income (loss) per share of Common Stock and equivalents                          |       | $                                           | 0.56       |   | $ | 0.01 |   | $ | (0.17 | ) |

 

Directors, officers and certain key employees of ISSwere issued 56,000 and 316,000 restricted shares in 2005 and 2004, respectively.In 2005, 33,000 restricted shares were returned prior to vesting. The sharesissued to directors vest when the Company holds its annual stockholders meetingand the shares issued to officers and certain key employees vest in twoinstallments: 50% vests two years from the grant date, and the remaining 50%vests three years from the grant date. Upon issuance of restricted shares,unearned compensation is recorded in stockholders’ equity as deferredcompensation equal to the market value of the restricted shares and isrecognized as compensation expense over the vesting period. Total compensationexpense for restricted stock awards amounted to $2,107,000 and $2,019,000 in2005 and 2004, respectively.

Inputsused for the fair value method for our employee stock options are as follows:

| ** **                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Volatility                                                         |       | 41                                          | %          | 49 | % | 75 | % |
| Weighted-average  expected lives (in years)                        |       | 4.6                                         |       | 5 |   | 5 |   |
| Expected dividend  yields                                          |       | —                                      |       | — |   | — |   |
| Weighted-average  risk-free interest rates                         |       | 3.89                                        | %          | 3.66 | % | 2.54 | % |
| Weighted-average  fair value per share of options granted          |       | $                                           | 7.81       |   | $ | 7.87 |   | $ | 6.90 |   |
| Weighted-average fair  value per share of restricted stock awarded |       | $                                           | 23.02      |   | $ | 17.45 |   | — |   |
|                                                                    |            |                                             |            |  |  |  |  |  |  |  |

 

**Accountingfor Issuances of Stock by a Subsidiary**

When one of the Company’ssubsidiaries issues shares of its stock at an amount different than the Company’scarrying value for the subsidiary’s stock, the Company records the differenceas a gain or loss in the consolidated statements of operations, in accordancewith SEC Staff Accounting Bulletin No. 51, if the 

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transactionmeets the following conditions: (1) the sale of such shares is not a partof a broader corporate reorganization contemplated or planned by the Company; (2) theCompany does not intend to spin-off the related subsidiary to stockholders; (3) reacquisitionof shares is not contemplated at the time of issuance; and (4) thesubsidiary is not a newly-formed, non-operating entity, a research anddevelopment start-up or development stage entity, or an entity whose ability tocontinue in existence is in question.

**AccumulatedOther Comprehensive Income**

Accumulated other comprehensiveincome at December 31, 2005, 2004 and 2003 consists of the cumulativeforeign currency translation adjustment.

**Income Per Share**

Basic net income per sharewas computed by dividing net income by the weighted average number of sharesoutstanding of Common Stock. Diluted net income per share was computed bydividing net income by the weighted average shares outstanding including commonequivalents (when dilutive) (see Note 10).

**RecentlyIssued Accounting Standards**

On December 16, 2004,the Financial Accounting Standards Board issued SFAS No. 123 (revised2004) (“SFAS No. 123(R)”), *Share-Based Payment,*whichis a revision of SFAS No. 123, *Accounting for Stock-BasedCompensation*. SFAS No. 123(R) supersedes APB No. 25and revises guidance in SFAS No. 123. Among other things, SFAS No. 123(R) requiresthat compensation expense be recognized in the financial statements forshare-based awards based on the grant date fair value of those awards. It alsorequires the benefits associated with tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow rather than as anoperating cash flow as currently required. The Company will adopt SFAS No. 123(R) onJanuary 1, 2006. Upon adoption, we will use the modified prospectivemethod and therefore will not restate our prior period results. SFAS No. 123(R) willapply to new share-based awards and to unvested stock options outstanding onthe effective date and issuances under our employee stock purchase plan.Unrecognized non-cash stock compensation expense related to unvested optionsoutstanding as of December 31, 2005 is approximately $26.9 million andwill be recorded over the remaining vesting period of four years. TheCompany currently utilizes the Black-Scholes option pricing model to estimatethe fair value for the pro forma net income and earnings per share calculationsin Note 1 and will continue using the model after adoption of SFAS No. 123(R).

In May 2005, the FASBissued SFAS No. 154, “*AccountingChanges and Error Corrections”.*SFAS No. 154 requiresretroactive application of a voluntary change in accounting principle to priorperiod financial statements unless it is impracticable. SFAS No. 154 alsorequires that a change in method of depreciation, amortization or depletion forlong-lived, non-financial assets be accounted for as a change in accountingestimate that is affected by a change in accounting principle. SFAS No. 154replaces APB Opinion No. 20, “*AccountingChanges”* and SFAS No. 3, “*ReportingAccounting Changes in Interim Financial Statements”.*SFAS No. 154is effective for fiscal years beginning after December 15, 2005. TheCompany does not expect the adoption of the provisions of SFAS No. 154 tohave a material impact on its results of operations or financial condition.

**2.   BUSINESSCOMBINATIONS AND ASSET ACQUISITIONS**

In January 2004,ISS acquired Cobion AG, a privately held company based in Kassel,Germany. Cobion provides content filtering and anti-spam technology thatprotects individuals and enterprises against unwanted Web content, spam, misuseof information and lost productivity. The Company is continuing to sell theCobion product on a stand-alone basis and to OEM partners to incorporatein their products as well as including the technology in the Company’s multi-functionProventia appliance. The operating results of the Company include the operatingresults of Cobion since the date of acquisition.

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Total cash consideration for all of the outstandingshares of Cobion and the acquisition related fees were approximately$33.5 million. The Company adopted a plan to restructure Cobion wherebycertain Cobion employees were terminated over a six-month period following theacquisition. As a result, acquisition costs included the accrual of $203,000 ofseverance costs associated with these terminations. The Company has paid allseverance costs and has no remaining liability related to these terminations.

The operatingresults of Cobion are included in the consolidated financial statements of ISSfrom the date of acquisition. The aggregate purchase price was allocated basedon a valuation report of the Cobion intangibles and purchase price adjustmentsas follows (in thousands):

| Net tangible  liabilities of Cobion |   | $      | (2,736 | )      |
|-------------------------------------|--------|--------|--------|--------|
| Developed  technology               |   | 16,030 |   |
| Customer  relationships             |   | 516    |   |
| Deferred income  taxes              |   | (1,772 | )      |
| Goodwill                            |   | 21,476 |   |
|                                |   | $      | 33,514 |   |

 

The Company is amortizing these intangible assets overtheir estimated useful lives of five years for developed technology and threeyears for customer relationships.

The tangible assets of Cobion acquired in the mergerconsisted primarily of cash, accounts receivable and fixed assets. Theliabilities of Cobion assumed in the merger consisted primarily of accountspayable, accrued expenses and deferred revenue.

The following summarizes the unaudited pro formaresults of operations of the Company for the year ended December 31, 2003assuming the acquisition of Cobion was concluded as of the beginning of 2003: (i) revenuesof $246 million, (ii) net income of $16 million (iii) basicand diluted net income per share of Common Stock of $0.32. Net income and basicand diluted net income per share have been adjusted to reflect the amortizationof intangibles identified above. Unaudited pro forma results are not includedfor the corresponding period of 2004 as the impact of the acquisition wouldhave been immaterial to the consolidated results of operations. This pro formainformation is not necessarily indicative of what combined operations wouldhave been if ISS had control of Cobion from the beginning of 2003.

In August 2002, ISSKK, our Asia/Pacific subsidiary, acquired a distributor in Singapore,TriSecurity Holdings Pte Ltd. (“TriSecurity”). TriSecurity was the soledistributor for ISS KK in southeast Asia, including India, and its business wasalmost exclusively focused on ISS solutions. This acquisition provides ourAsia-Pacific subsidiary direct support capabilities for their customers inSoutheast Asia and allows ISS KK to expand its capabilities in thisgrowing market. The consideration consisted of 2,000 shares of ISS KKstock and approximately $1.2 million of cash. Goodwill of approximately$4.0 million related to the purchase was recorded. During the firstquarter of 2003, ISS KK amended the agreement and agreed to make payment of490 shares of ISS KK in each of the first quarters of 2004 and 2005,relating to annual contingent consideration payments under the 2002 purchaseagreement. Due to regulatory issues, the agreement was amended prior to the2004 payment to make the 2004 and 2005 payments in cash in lieu of shares. Additionalconsideration of $764,000 and $498,000 was paid in February 2005 and 2004,respectively, based on the fair market value of the 490 shares, and isreflected in goodwill.

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**3.   MARKETABLE SECURITIES**

Thefollowing is a summary of available-for-sale marketable securities, which arerecorded at fair market value, as of December 31:

| ** **                                                   | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|--------------------------------------------------------------|------------|-----------|------------|------------|------------|
| Unrestricted marketable  securities:                         |       |      |       |       |       |
| Corporate securities                                         |       | $         | —     |       | $          | 28,146,000 |   |
| Taxable auction rate securities                              |       | —    |       | 27,300,000 |       |
| U.S. government and government-sponsored securities          |       | —    |       | 15,455,000 |       |
| Total unrestricted marketable securities                     |       | $         | —     |       | $          | 70,901,000 |   |
| Restricted cash  and marketable securities:                  |       |      |       |       |       |
| Corporate securities                                         |       | $         | 1,389,000  |       | $          | 4,772,000 |   |
| Taxable auction rate securities                              |       | —    |       | 2,450,000  |       |
| US government and government-sponsored securities            |       | 791,000   |       | 3,078,000  |       |
| Cash equivalents                                             |       | 6,420,000 |       | —     |       |
| Total restricted  marketable securities and cash equivalents |       | $         | 8,600,000  |       | $          | 10,300,000 |   |

 

As of December 31,2005 and 2004, the cost of marketable securities approximated fair value. Thecontractual maturities of the corporate securities and the U.S. governmentand government-sponsored securities were all less than one year as of December 31,2005. Cash and marketable securities of $8,600,000 at December 31, 2005and $10,300,000 at December 31, 2004 were restricted as collateral forletters of credit issued in relation to operating leases for facilities.

**4.   STOCK OPTION PLANS**

The Internet Security Systems, Inc. 2005 StockIncentive Plan (“the Plan”) consists of equity programs that provide for thegranting of qualified or non-qualified stock options, the issuance of stock andthe automatic option grant program. Under the terms of the plan the exerciseprice of options granted shall not be less than the fair market value on thedate of grant, the options have a maximum term of seven years and generallyvest over a four-year period. Stock issued under the Plan generally vests overa period of service or attainment of specified performance objectives. Theautomatic option grant program is available to the non-employee members of theCompany’s board of directors. At December 31, 2005 there were 7,250,000shares reserved for future issuance. An additional 80,000 shares have beenreserved for non-statutory options issued in 1997 to non-employee directors.

A summary of ISS’ stockoption activity is as follows:

| ** **                              | ** ** | **2005**           | ** ** | **2004**                        | ** ** | **2003**           | ** ** |
|-----------------------------------------|------------|--------------------|------------|---------------------------------|------------|--------------------|------------|
| ** **                              | ** ** | **Number of** | ** ** | **Weighted  Average  Exercise** | ** ** | **Number of** | ** ** | **Weighted  Average  Exercise** | ** ** | **Number of** | ** ** | **Weighted  Average  Exercise** | ** ** |
| ** **                              | ** ** | **Shares**         | ** ** | **Price**                       | ** ** | **Shares**         | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Outstanding at  beginning of year  |       | 8,845,000          |       |                            | $          | 20.82              |       |   | 7,637,000 |   |   | $ | 22.26 |   |   | 6,756,000 |   |   | $ | 31.64 |   |   |
| Granted                                 |       | 2,616,000          |       |                            | 20.64      |               |       | 2,668,000 |   |   | 16.69 |   |   | 2,898,000 |   |   | 11.14 |   |   |
| Exercised                               |       | (1,372,000         | )          |                            | 13.70      |               |       | (493,000 | ) |   | 11.95 |   |   | (136,000 | ) |   | 7.50 |   |   |
| Canceled                                |       | (762,000           | )          |                            | 18.42      |               |       | (967,000 | ) |   | 25.38 |   |   | (1,881,000 | ) |   | 39.95 |   |   |
| Outstanding at end of year              |       | 9,327,000          |       |                            | $21.93     |               |       | 8,845,000 |   |   | $20.82 |   |   | 7,637,000 |   |   | $22.26 |   |   |
| Exercisable at  end of year             |       | 5,493,000          |       |                            | $24.35     |               |       | 5,242,000 |   |   | $23.55 |   |   | 2,840,000 |   |   | $28.19 |   |   |

 

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All options assumed by ISS in acquisitions wereincluded in the respective purchase price based on their fair value. Theintrinsic value of the unvested options has been allocated to deferredcompensation and is being amortized over the remaining vesting periods of therelated options. The Company recorded deferred compensation of approximately$6.4 million for options assumed in the June 2001 acquisition ofNetwork ICE and the October 2002 acquisition of vCIS, Inc.Amortization of deferred compensation related to these options was $78,000 in2004 and $361,000 in 2003, and it was fully amortized as of December 31,2004.

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| ** **                                  | ** ** | **Options Outstanding**                                        | ** ** | **Options Fully  Vested and Exercisable** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                  | ** ** | **Number of  Options  Outstanding at  December 31,** | ** ** | **Weighted  Average  Remaining  Contractual**            | ** ** | **Weighted  Average  Exercise** | ** ** | **Number  Exercisable  at  December 31,** | ** ** | **Weighted  Average  Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | ** **                                                          | ** ** | **2005**                                                 | ** ** | **Life** | ** ** | **Price** | ** ** | **2005** | ** ** | **Price** | ** ** |
| $.08-9.11                                   |       |                                                                | 242,000    |                                                     |       |   | 3.28 |   |   |   | $ | 5.32 |   |   |   | 242,000 |   |   |   | $ | 5.32 |   |   |
| $10.00-19.98                                |       |                                                                | 4,642,000  |                                                     |       |   | 6.36 |   |   |   | 14.63 |   |   |   | 2,595,000 |   |   |   | 14.22 |   |   |
| $20.03-29.44                                |       |                                                                | 2,638,000  |                                                     |       |   | 6.06 |   |   |   | 22.08 |   |   |   | 857,000 |   |   |   | 21.79 |   |   |
| $30.63-39.75                                |       |                                                                | 1,150,000  |                                                     |       |   | 5.84 |   |   |   | 32.95 |   |   |   | 1,144,000 |   |   |   | 32.95 |   |   |
| $49.81-85.63                                |       |                                                                | 655,000    |                                                     |       |   | 4.70 |   |   |   | 59.86 |   |   |   | 655,000 |   |   |   | 59.86 |   |   |
|                                        |       |                                                                | 9,327,000  |                                                     |       |   | 6.01 |   |   |   | $ | 21.93 |   |   |   | 5,493,000 |   |   |   | $ | 24.35 |   |   |
|                                             |            |                                                                     |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

On October 29, 2003,ISS announced a voluntary option exchange program intended to reduce the numberof outstanding options. Stock options with exercise prices exceeding$30 per share were eligible. ISS’ directors and five most senior executiveofficers, including the chief executive officer, were not eligible toparticipate in the program. Approximately 783,000 option shares, of the1,343,000 eligible, with exercise prices between $30 and $83 per shareelected into the program. On June 1, 2004 the Company granted 313,000 newoptions at the fair market value on that date.

**5.   ADOPTIONOF SHAREHOLDER RIGHTS PLAN**

On July 11, 2002, the Board of Directors adopteda shareholder rights plan and authorized and declared a dividend of onepreferred share purchase right (a “Right”) for each outstanding share of CommonStock, par value $.001 per share, of the Company. The dividend was paid onJuly 29, 2002 to the stockholders of record on that date. Stock issuedsubsequent to July 29, 2002 will be issued with an attached Right. EachRight will initially represent the right, under certain circumstances, topurchase one one-thousandth of a share of Series A Junior ParticipatingPreferred Stock (the “Junior Preferred Stock”) at a purchase price of$80 per one one-thousandth of a share. If a person or group acquiresbeneficial ownership of 20% or more of the then outstanding shares of theCompany’s Common Stock (an “Acquiring Person”), the holder of a Right, uponexercise of the Right, will thereafter have the right to receive, in lieu ofshares of Junior Preferred Stock, shares of the Company’s Common Stock (or, incertain circumstances, cash, property or other securities of the Company)having a value equal to twice the purchase price of the Right.

The Rights expire on July 11, 2012. Generally,the Board of Directors may redeem the Rights at a price of $.001 per Right(subject to adjustment) at any time prior to the earlier of (i) the closeof business on the tenth business day following the date a person becomes anAcquiring Person or (ii) the expiration date of the Rights. Prior to anyperson or group becoming an Acquiring Person, the Company may amend the RightsAgreement at any time.

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In addition, the Companyhas retention agreements with certain officers of the Company which provide forseverance payments upon a termination that is a result of a change in control,as described in the agreements.

**6.   OTHER INCOME (EXPENSE)**

Other expense in 2005 and 2004 includes write-offs ofan investment made by ISS KK in a Taiwan distributor of approximately $175,000and $498,000, respectively. The Company completed an impairment analysis of theTaiwan distributor’s financial results. Upon reviewing the results, the Companydetermined the investment was impaired. As of December 31, 2005, thisinvestment has been fully written-off.

Other expense for 2003 includes a $2.2 millionwrite off of an investment made by ISS KK in a China distributor. The Companycompleted an impairment analysis on the China distributor’s March 2003annual financial results issued and made available in the fourth quarter of2003. Upon reviewing these results, the Company determined the investment wasimpaired and concluded that a write-off of the entire investment wasappropriate.

Minority interest expensetotaled $257,000 in 2005, $637,000 in 2004 and $157,000 in 2003. Minorityinterest in earnings of consolidated subsidiaries represents the minorityshareholders’ share of the after-tax net income or loss. Foreign currencyexchange loss in 2005 totaled $1.2 million versus gains of $401,000 and$813,000 in 2004 and 2003, respectively.

**7.   COMMITMENTS AND CONTINGENCIES**

ISShas non-cancelable operating leases for facilities that expire at various datesthrough 2013. The Company has shorter-term leases for office space in otherlocations and various computer equipment leases. Future minimum payments undernon-cancelable operating leases with initial terms of one year or moreconsisted of the following at December 31, 2005:

| ** **                    | ** ** | **Non-Cancelable  Operating Leases** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| 2006                          |       |                                      | $          | 12,372,000 |   |   |
| 2007                          |       |                                      | 10,023,000 |   |   |
| 2008                          |       |                                      | 8,949,000  |   |   |
| 2009                          |       |                                      | 7,583,000  |   |   |
| 2010                          |       |                                      | 7,609,000  |   |   |
| Thereafter                    |       |                                      | 19,579,000 |   |   |
| Total minimum  lease payments |       |                                      | $          | 66,115,000 |   |   |

 

Rent expense was approximately $12,701,000,$13,825,000 and $14,469,000 for the years ended December 31, 2005, 2004and 2003, respectively.

Our sales agreements with customers generally containinfringement indemnity provisions. We have not previously incurred costs tosettle claims or pay awards under these indemnification obligations. As aresult, we believe the estimated fair value of these obligations is nominal.Accordingly, we have no liabilities recorded for these agreements as of December 31,2005. In addition, we warrant that our software products will perform in allmaterial respects in accordance with our standard published specifications ineffect at the time of delivery of the licensed products to the customer forninety days. We also warrant that for one year after shipment, all hardwarewill be free from defects in materials and workmanship under normal authorizeduse, consistent with the instructions contained in the product documentation.Additionally, we warrant that our services will be performed consistent withgenerally accepted industry standards or specific service levels throughcompletion of the agreed upon services. We 

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have not incurredsignificant recurring expense under our product or service warranties andhardware warranties are covered by the manufacturer warranties. As a result, webelieve the estimated fair value of these agreements is nominal. Accordingly,we have no liabilities recorded for these agreements as of December 31,2005.

Payments for certain operating leases for our officespace are secured by collateralized standby letters of credit totaling$7.3 million at December 31, 2005. These standby letters of creditguarantee payments on certain lease obligations and are renewed annually unlesscancelled by either party. The lease obligations have terms that expire atvarious dates through 2013. The beneficiary of the standby letters of creditcan draw on the letters of credit if we default on the related leaseobligation. Each standby letter of credit is collateralized by securities. At December 31,2005, $8.6 million of cash and marketable securities are pledged ascollateral and are shown on the balance sheet as restricted cash and marketablesecurities.

On August 17, 2004,the Company’s Georgia operating subsidiary filed in the United States DistrictCourt for the Northern District of Georgia a declaratory judgment action (the “GeorgiaAction”) against SRI International, Inc. (“SRI”). The action seeks thecourt’s declaration that our products and services do not infringe any validclaim of five patents held by SRI and seeks declaration that certain claims ofthose patents are invalid. On August 26, 2004, SRI filed in the UnitedStates District Court for Delaware a complaint against the Company and SymantecCorporation (the “Delaware Action”). The complaint in the Delaware Actionalleges that our SiteProtector and Proventia products infringe upon claims oftwo of the five patents at issue in the Georgia Action. The Delaware Actionseeks unspecified damages and injunctive relief. On April 25, 2005, SRIfiled an amended complaint adding the Company’s Georgia operating subsidiary asa separate defendant to the Delaware Action. The Company and its subsidiaryanswered SRI’s amended complaint on May 23, 2005, denying that theyinfringe the two patents asserted by SRI and asserting counterclaims seeking adeclaration from the Delaware court that the five SRI patents are notinfringed, and are invalid and unenforceable. On June 9, 2005, the Georgiacourt transferred the Georgia Action to the United States District Court forthe District of Delaware. The transferred action was consolidated with theDelaware Action. On June 13, 2005, SRI answered the counterclaims assertedby the Company and its subsidiary, denying that the five patents are notinfringed, invalid, and unenforceable. On August 5, 2005, SRI granted tothe Company a covenant never to sue the Company, its distributors, customers,licensees or end users, for damages or any other form of legal or equitablerelief based on or arising out of the alleged infringement of one of the fivepatents-in-suit as a result of the manufacture, use, sale, offer for sale,importation, maintenance, support or servicing of any Company product orservice existing on or before the effective date. The parties are currentlyengaged in discovery on the remaining claims, and trial has been scheduled tobegin on or about October 30, 2006. We intend to defend the DelawareAction vigorously and believe we have meritorious defenses and counterclaims. Dueto the uncertainty surrounding the litigation process and the early stage ofthe proceedings, the Company is unable to reasonably estimate a range of loss,if any, at this time.

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**8.   INCOME TAXES**

Thecomponents of the provision for income taxes were as follows:

| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:                          |       |                                       |       |   |   |   |   |
| Federal                           |       | $                                          | 16,959,000 |   | $ | 1,563,000 |   | $ | 8,069,000 |   |
| State, net of federal benefit     |       | 1,778,000                                  |       | 636,000 |   | 1,377,000 |   |
| Foreign                           |       | 4,403,000                                  |       | 3,340,000 |   | 3,346,000 |   |
|                              |       | 23,140,000                                 |       | 5,539,000 |   | 12,792,000 |   |
| Deferred:                         |       |                                       |       |   |   |   |   |
| Federal                           |       | (316,000                                   | )          | 11,270,000 |   | — |   |
| State, net of federal benefit     |       | (285,000                                   | )          | 547,000 |   | — |   |
| Foreign                           |       | (143,000                                   | )          | (1,963,000 | ) | (1,561,000 | ) |
|                              |       | (744,000                                   | )          | 9,854,000 |   | (1,561,000 | ) |
| Total provision  for income taxes |       | $                                          | 22,396,000 |   | $ | 15,393,000 |   | $ | 11,231,000 |   |

 

Pre-taxincome attributable to foreign and domestic operations is summarized below:

| ** **               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| U.S. operations     |       | $                                          | 47,591,000 |   | $ | 33,458,000 |   | $ | 27,838,000 |   |
| Asia Pacific  operations |       | 9,958,000                                  |       | 5,509,000 |   | 694,000 |   |
| EMEA operations          |       | 2,975,000                                  |       | 2,074,000 |   | 1,424,000 |   |
| Other                    |       | 417,000                                    |       | 645,000 |   | 1,012,000 |   |
|                     |       | $60,941,000                                |       | $ | 41,686,000 |   | $ | 30,968,000 |   |
|                          |            |                                            |            |  |  |  |  |  |  |  |

 

Areconciliation of the provision for income taxes to the amount computedpursuant to the statutory federal income tax rate is as follows:

| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal income  taxes at 35% applied to pretax income  |       | $                                          | 21,329,000 |   | $ | 14,590,000 |   | $ | 10,839,000 |   |
| State income  taxes, net of federal income tax benefit |       | 1,487,000                                  |       | 1,182,000 |   | 1,377,000 |   |
| Research and  development tax credits                  |       | (489,000                                   | )          | 233,000 |   | (1,300,000 | ) |
| Foreign  operations differential in rate               |       | 331,000                                    |       | (760,000 | ) | (19,000 | ) |
| Deferred  compensation                                 |       | —                                     |       | 30,000 |   | 127,000 |   |
| Change in  valuation allowance                         |       | (110,000                                   | )          | (400,000 | ) | — |   |
| Other                                                  |       | (152,000                                   | )          | 518,000 |   | 207,000 |   |
|                                                   |       | $22,396,000                                |       | $ | 15,393,000 |   | $ | 11,231,000 |   |
|                                                        |            |                                            |            |  |  |  |  |  |  |  |

 

Income taxes payable were $13.2 million and $3.9million at December, 31, 2005 and 2004, respectively. These amounts areincluded in accrued liabilities on the balance sheet.

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Deferredincome taxes reflect the net income tax effects of temporary differencesbetween the carrying amounts of assets and liabilities for financial reportingpurposes and the amounts used for income tax purposes. Significant componentsof the Company’s net deferred income taxes are as follows:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred income tax  liabilities:                  |       |                  |       |   |   |
| Amortization                                       |       | $                     | 3,468,000  |   | $ | 6,383,000 |   |
| Gain of issuance of  subsidiary stock              |       | 6,696,000             |       | 6,612,000 |   |
| Other                                              |       | 11,000                |       | — |   |
| Total deferred income  tax liabilities             |       | 10,175,000            |       | 12,995,000 |   |
| Deferred income tax  assets:                       |       |                  |       |   |   |
| Depreciation                                       |       | 841,000               |       | 930,000 |   |
| Accrued liabilities                                |       | 1,174,000             |       | 1,115,000 |   |
| Allowance for doubtful  accounts                   |       | 1,094,000             |       | 868,000 |   |
| Deferred revenue                                   |       | 4,362,000             |       | 2,263,000 |   |
| Deferred compensation                              |       | 1,396,000             |       | — |   |
| Loss from impairment of  investment                |       | 248,000               |       | 1,145,000 |   |
| Net operating loss  carryforwards                  |       | 5,609,000             |       | 7,231,000 |   |
| Foreign tax credit  carryforwards                  |       | 175,000               |       | — |   |
| Research and development  tax credit carryforwards |       | —                |       | 3,918,000 |   |
| Other                                              |       | 217,000               |       | — |   |
| Total deferred income  tax assets                  |       | 15,116,000            |       | 17,470,000 |   |
| Net deferred tax income  tax asset                 |       | 4,941,000             |       | 4,475,000 |   |
| Less valuation allowance                           |       | (2,198,000            | )          | (3,301,000 | ) |
| Net deferred income tax assets                     |       | $                     | 2,743,000  |   | $ | 1,174,000 |   |

 

The change in valuation allowance includes twocomponents. The first component is the removal of approximately $110,000 ofvaluation allowance related to the net operating loss carryforward for ourBelgium subsidiary. Management’s evaluation of all of the available evidence inassessing the realizability of the tax benefits of the loss carryforwardindicates the company will likely realize a benefit for this loss.

The other component is a reduction of $993,000 ofvaluation allowance related to net operating loss carryforwards for certaincountries in the EMEA and Asia/Pacific regions for which the deferred taxassets are fully offset by a valuation allowance. The Company has notrecognized any benefit from the future use of the deferred income tax assetsrelated to these operations because management’s evaluation of all theavailable evidence in assessing the realizability of the tax benefits of suchloss carryforwards indicates that the underlying assumptions of futureprofitable operations contain risks that do not provide sufficient assurance torecognize such tax benefits currently. The net change in this asset and correspondingvaluation allowance during 2005 is reflected in the rate reconciliation aboveas part of the foreign operations differential in rate item.

The Company’s net operating loss carryforwards areprimarily from the EMEA region and can be carried forward indefinitely.

The American Jobs Creation Act of 2004 (the “JobsCreation Act”) creates a temporary incentive for U.S. corporations torepatriate accumulated income earned abroad by providing an 85%dividends-received deduction for certain dividends from controlled foreigncorporations. As of December 31, 2005 management has determined not torepatriate foreign earnings under the Jobs Creation Act and accordingly noprovision for taxes on the unremitted foreign earnings has been recorded in theconsolidated financial statements.

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**9.   EMPLOYEE STOCK AND BENEFIT PLANS**

ISS sponsors a 401(k) plan that coverssubstantially all employees over 18 years of age. Participating employeesmay contribute up to 100% of their pre-tax salary, but not more than statutorylimits. The Company matches 25% of participant contributions up to 3% of theirpre-tax salary. Matching contributions of $364,000 in 2005, $323,000 in 2004and $437,000 in 2003 were charged to expense.

Effective July 1,1999, the Company implemented an employee stock purchase plan (the “Plan”) forall eligible employees. Under the Plan, shares of the Company’s Common Stockmay be purchased at six-month intervals at 85% of the lower of the fair marketvalue on the first or the last day of each six-month period. Employees maypurchase shares with aggregate fair value up to 10% of their gross compensationduring a six-month period. Employees purchased 56,000 shares at an averageprice of $13.02 in 2005, 126,000 shares at an average price of $11.23 in2004 and 150,000 shares at an average price of $10.53 per share in2003. At December 31, 2005, 78,000 shares of the Company’s CommonStock were reserved for future issuance. The Company suspended employeedeposits into the Plan for 2005 to determine the effects of expensing stockoptions under Financial Accounting Standards Board SFAS No. 123(R), *“Share-Based Payment”,* which is a revisionof SFAS No. 123,*“Accounting forStock-Based Compensation”.*(See Recently Issued Accounting Standardsunder Significant Accounting Policies.) The Company may reinstate the Plan withmodifications or discontinue the plan entirely.

**10.   INCOME PER SHARE**

Thefollowing table sets forth the computation of basic and diluted net income pershare:

| ** **                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                                                                 |       |                                       |       |   |   |   |   |
| Net income                                                                                 |       | $                                          | 38,545,000 |   | $ | 26,293,000 |   | $ | 19,737,000 |   |
| Denominator:                                                                               |       |                                       |       |   |   |   |   |
| Denominator for basic net income per share—weighted  average shares                   |       | 45,037,000                                 |       | 46,985,000 |   | 49,155,000 |   |
| Effect of dilutive stock options                                                           |       | 2,224,000                                  |       | 1,473,000 |   | 863,000 |   |
| Denominator for diluted net income per  share—weighted average shares and equivalents |       | 47,261,000                                 |       | 48,458,000 |   | 50,018,000 |   |
| Basic net income per share                                                                 |       | $                                          | 0.86       |   | $ | 0.56 |   | $ | 0.40 |   |
| Diluted net  income per share                                                              |       | $                                          | 0.82       |   | $ | 0.54 |   | $ | 0.39 |   |

 

In addition, 2,346,000shares in 2005, 2,237,000 in 2004 and 3,837,000 in 2003 were not included inthe fully diluted computation because they would have been antidilutive.

**11.   SEGMENTSAND GEOGRAPHIC INFORMATION**

ISS conducts business in one operating segment: providinginformation security management solutions. The Company does, however, prepareoperating results for internal use on a geographic basis. These geographicalbased operating costs consist of direct sales expenses, infrastructure tosupport its employee and customer and partner base, supporting billing andfinancial systems and a management team for the geographic segment. Corporateexpenses that are not charged directly to the other segments include researchand development, general and administrative costs that support the globalorganization, amortization of acquired technology, amortization of licenseddevelopment source code, amortization of intangibles and stock-basedcompensation and costs that are one-time in nature, such as acquired in-processresearch and development.

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The accountingpolicies of the segments are the same as those described in the summary ofsignificant accounting policies. There are no inter-segment sales. Our chiefexecutive officer and chief financial officer evaluate performance based onoperating profit or loss from operations, and trade accounts receivable foreach segment. Other than trade accounts receivable, assets and liabilities arenot discretely allocated or reviewed by segment.

Inaccordance with SFAS No. 131,*“Disclosuresabout Segments of an Enterprise and Related Information”*, theCompany has included a summary of the segment financial information reportedinternally. The geographic segments are the Americas, EMEA, and theAsia/Pacific region.

| ** **                                              | ** ** | **Americas** | ** ** | **EMEA**   | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total**  | ** ** |
|---------------------------------------------------------|------------|--------------|------------|------------|------------|------------------|------------|-----------------|------------|------------|------------|
| **As of or for the year ended December 31, 2005**       |       |         |       |       |       |             |       |            |       |       |       |   |   |
| **Revenues from external customers:**                   |       |         |       |       |       |             |       |            |       |       |       |   |   |
| Product licenses and  sales                             |       | $            | 90,774,000 |       | $          | 31,690,000       |       |            | $          | 23,883,000 |       |   | $ | — |   | $ | 146,347,000 |   |
| Subscriptions                                           |       | 102,310,000  |       | 37,361,000 |       |             | 21,430,000 |            |       | —     |       | 161,101,000 |   |
| Professional services                                   |       | 15,088,000   |       | 2,318,000  |       |             | 4,918,000  |            |       | —     |       | 22,324,000 |   |
| Total revenue                                           |       | 208,172,000  |       | 71,369,000 |       |             | 50,231,000 |            |       | —     |       | 329,772,000 |   |
| **Cost of revenues:**                                   |       |         |       |       |       |             |       |            |       |       |       |   |   |
| Product licenses and  sales                             |       | 17,174,000   |       | 5,392,000  |       |             | 4,787,000  |            |       | 1,500,000  |       | 28,853,000 |   |
| Amortization of acquired  technology                    |       | —       |       | —     |       |             | —     |            |       | 6,985,000  |       | 6,985,000 |   |
| Subscriptions and  professional services                |       | 36,869,000   |       | 5,352,000  |       |             | 10,608,000 |            |       | —     |       | 52,829,000 |   |
| Total cost of revenues                                  |       | 54,043,000   |       | 10,744,000 |       |             | 15,395,000 |            |       | 8,485,000  |       | 88,667,000 |   |
| **Operating  expenses**                                 |       | 67,958,000   |       | 31,661,000 |       |             | 9,289,000  |            |       | 75,526,000 |       | 184,434,000 |   |
| **Total  expenses**                                     |       | 122,001,000  |       | 42,405,000 |       |             | 24,684,000 |            |       | 84,011,000 |       | 273,101,000 |   |
| **Segment  operating income (loss)**                    |       | $            | 86,171,000 |       | $          | 28,964,000       |       |            | $          | 25,547,000 |       |   | $ | (84,011,000 | ) | $ | 56,671,000 |   |
| **Accounts  receivable, net**                           |       | $            | 53,208,000 |       | $          | 22,468,000       |       |            | $          | 12,093,000 |       |   | $ | — |   | $ | 87,769,000 |   |
| **Property  and equipment, net**                        |       | $            | 23,401,000 |       | $          | 1,730,000        |       |            | $          | 4,220,000  |       |   | $ | — |   | $ | 29,351,000 |   |
| **As of or for the year ended December 31,  2004** |       |         |       |       |       |             |       |            |       |       |       |   |   |
| **Revenues from external customers:**                   |       |         |       |       |       |             |       |            |       |       |       |   |   |
| Product licenses and  sales                             |       | $            | 75,231,000 |       | $          | 30,347,000       |       |            | $          | 20,534,000 |       |   | $ | — |   | $ | 126,112,000 |   |
| Subscriptions                                           |       | 94,346,000   |       | 30,836,000 |       |             | 15,511,000 |            |       | —     |       | 140,693,000 |   |
| Professional services                                   |       | 14,417,000   |       | 3,387,000  |       |             | 5,284,000  |            |       | —     |       | 23,088,000 |   |
| Total revenue                                           |       | 183,994,000  |       | 64,570,000 |       |             | 41,329,000 |            |       | —     |       | 289,893,000 |   |
| **Cost of revenues:**                                   |       |         |       |       |       |             |       |            |       |       |       |   |   |
| Product licenses and  sales                             |       | 13,093,000   |       | 4,130,000  |       |             | 3,665,000  |            |       | 1,500,000  |       | 22,388,000 |   |
| Amortization of acquired  technology                    |       | —       |       | —     |       |             | —     |            |       | 6,851,000  |       | 6,851,000 |   |
| Subscriptions and  professional services                |       | 33,519,000   |       | 5,226,000  |       |             | 10,254,000 |            |       | —     |       | 48,999,000 |   |
| Total cost of revenues                                  |       | 46,612,000   |       | 9,356,000  |       |             | 13,919,000 |            |       | 8,351,000  |       | 78,238,000 |   |
| **Operating  expenses**                                 |       | 63,052,000   |       | 28,875,000 |       |             | 9,036,000  |            |       | 70,949,000 |       | 171,912,000 |   |
| **Total  expenses**                                     |       | 109,664,000  |       | 38,231,000 |       |             | 22,955,000 |            |       | 79,300,000 |       | 250,150,000 |   |
| **Segment  operating income (loss)**                    |       | $            | 74,330,000 |       | $          | 26,339,000       |       |            | $          | 18,374,000 |       |   | $ | (79,300,000 | ) | $ | 39,743,000 |   |
| **Accounts  receivable, net**                           |       | $            | 40,182,000 |       | $          | 20,866,000       |       |            | $          | 14,305,000 |       |   | $ | — |   | $ | 75,353,000 |   |
| **Property  and equipment, net**                        |       | $            | 27,117,000 |       | $          | 1,759,000        |       |            | $          | 5,564,000  |       |   | $ | — |   | $ | 34,440,000 |   |
| **As of or for the year ended December 31,  2003** |       |         |       |       |       |             |       |            |       |       |       |   |   |
| **Revenues from external customers:**                   |       |         |       |       |       |             |       |            |       |       |       |   |   |
| Product licenses  and sales                             |       | $            | 69,540,000 |       | $          | 22,961,000       |       |            | $          | 14,616,000 |       |   | $ | — |   | $ | 107,117,000 |   |
| Subscriptions                                           |       | 82,755,000   |       | 19,580,000 |       |             | 10,520,000 |            |       | —     |       | 112,855,000 |   |
| Professional  services                                  |       | 15,997,000   |       | 4,390,000  |       |             | 5,422,000  |            |       | —     |       | 25,809,000 |   |
| Total revenue                                           |       | 168,292,000  |       | 46,931,000 |       |             | 30,558,000 |            |       | —     |       | 245,781,000 |   |
| **Cost of revenues:**                                   |       |         |       |       |       |             |       |            |       |       |       |   |   |
| Product licenses  and sales                             |       | 7,437,000    |       | 1,136,000  |       |             | 955,000    |            |       | —     |       | 9,528,000 |   |
| Amortization of  acquired technology                    |       | —       |       | —     |       |             | —     |            |       | 4,404,000  |       | 4,404,000 |   |
| Subscriptions and  professional services                |       | 32,629,000   |       | 7,209,000  |       |             | 8,848,000  |            |       | —     |       | 48,686,000 |   |
| Total cost of  revenues                                 |       | 40,066,000   |       | 8,345,000  |       |             | 9,803,000  |            |       | 4,404,000  |       | 62,618,000 |   |
| **Operating  expenses**                                 |       | 58,909,000   |       | 21,271,000 |       |             | 7,272,000  |            |       | 66,115,000 |       | 153,567,000 |   |
| **Total  expenses**                                     |       | 98,975,000   |       | 29,616,000 |       |             | 17,075,000 |            |       | 70,519,000 |       | 216,185,000 |   |
| **Segment  operating income (loss)**                    |       | $            | 69,317,000 |       | $          | 17,315,000       |       |            | $          | 13,483,000 |       |   | $ | (70,519,000 | ) | $ | 29,596,000 |   |
| **Accounts  receivable, net**                           |       | $            | 38,046,000 |       | $          | 17,605,000       |       |            | $          | 10,937,000 |       |   | $ | — |   | $ | 66,588,000 |   |
| **Property  and equipment, net**                        |       | $            | 28,054,000 |       | $          | 1,528,000        |       |            | $          | 6,237,000  |       |   | $ | — |   | $ | 35,819,000 |   |

 

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**12.   ISSUANCESOF STOCK BY A SUBSIDIARY**

The following are issuances of the common stock of ourAsia/Pacific subsidiary, ISS KK. As disclosed in Note 1, the Companyreports a gain on the difference between the fair market value of the sharesissued and the book value of those shares, in accordance with the SEC StaffAccounting Bulletin No. 51 and company policy.

In 2005, 2004, and 2003,the Company’s Asia/Pacific subsidiary issued shares related to the exercise ofISS KK stock options. In February 2005, the Board of Directors of ISS KKinitiated a two-for-one stock split. All share and per share amounts have beenrestated for this stock split. In 2005, Asia/Pacific issued 1,048 shares at anaverage exercise price of approximately $476 per share. The net cash proceedswere $499,000 and the Company recorded a gain of $221,000 on the issuance ofthese shares. The Company’s ownership percentage of the subsidiary decreased to86% at December 31, 2005. In 2004, Asia/Pacific issued 1,048 shares at anaverage exercise price of approximately $431 per share. The net cash proceedswere $453,000 and the Company recorded a gain of $292,000 on the issuance ofthese shares. The Company’s ownership percentage of the subsidiary decreased to87% at December 31, 2004. In 2003 Asia/Pacific issued 908 shares atan average exercise price of $415 per share. The net cash proceeds were$376,000 and the Company recorded a gain of $249,000 on the issuance of theseshares. The Company’s ownership percentage of the subsidiary was at 88% in 2003.Deferred income taxes have been provided in the period in which the gains wererecognized.

**13.**   EXIT OR DISPOSALACTIVITIES

In the fourth quarter of 2003, the Company committedto a plan of cost reduction and exit activities aggregating $1.5 millionthrough the closing of its engineering operations in Reading, U.K. andSydney, Australia. These costs are included in research and developmentexpenses in the statement of operations. Additionally, the Company consolidatedcertain European operational responsibilities into U.S. operations. Theseexit costs of approximately $326,000 are included in the EMEA costs ofsubscriptions and services in the statement of operations.

At December 31, 2003the Company had accrued the following costs associated with these exitactivities: one-time termination benefits of $152,000; contract terminationcosts of $184,000; and other costs of $31,000. One-time termination benefitsconsisted of severance and benefits for involuntarily terminated employees. Thecontract termination costs include costs for remaining lease payments onvacated facilities and costs associated with vacating the facility. Other costsconsisted primarily of write-off of abandoned fixed assets and the write-off ofleasehold improvements related to the vacated facilities. At December 31,2004 all of the costs associated with these exit activities had been paid. TheCompany has no remaining liability associated with these exit activities at December 31,2005.

**14.**   QUARTERLY FINANCIAL RESULTS (UNAUDITED)

Summarizedquarterly results for the two years ended December 31, 2005 and 2004 areas follows:

| ** **             | ** ** | **Fourth** | ** ** | **Third**  | ** ** | **Second** | ** ** | **First**  | ** ** |
|------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| 2005 by quarter:       |       |       |       |       |       |       |       |       |       |
| Revenues               |       | $          | 91,035,000 |       | $          | 82,845,000 |       | $          | 79,100,000 |   | $ | 76,792,000 |   |
| Operating income       |       | 18,828,000 |       | 14,009,000 |       | 12,159,000 |       | 11,675,000 |       |
| Net income             |       | 12,647,000 |       | 9,792,000  |       | 8,261,000  |       | 7,845,000  |       |
| Net income per  share: |       |       |       |       |       |       |       |       |       |
| Basic                  |       | $          | 0.28       |       | $          | 0.22       |       | $          | 0.18       |   | $ | 0.17 |   |
| Diluted                |       | $          | 0.27       |       | $          | 0.21       |       | $          | 0.18       |   | $ | 0.16 |   |

 

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| ** **             | ** ** | **Fourth** | ** ** | **Third** | ** ** | **Second** | ** ** | **First** | ** ** |
|------------------------|------------|------------|------------|-----------|------------|------------|------------|-----------|------------|
| 2004 by quarter:       |       |       |       |      |       |       |       |      |       |
| Revenues               |       | $          | 80,556,000 |      | $          | 72,733,000 |       | $         | 69,540,000 |   | $ | 67,064,000 |   |
| Operating income       |       | 14,157,000 |       | 9,635,000 |       | 8,298,000  |       | 7,653,000 |       |
| Net income             |       | 9,202,000  |       | 6,411,000 |       | 5,460,000  |       | 5,220,000 |       |
| Net income per  share: |       |       |       |      |       |       |       |      |       |
| Basic                  |       | $          | 0.20       |      | $          | 0.14       |       | $         | 0.11       |   | $ | 0.11 |   |
| Diluted                |       | $          | 0.19       |      | $          | 0.14       |       | $         | 0.11       |   | $ | 0.10 |   |

 

Because of the method usedin calculating per share data, the quarterly per share data will notnecessarily total the per share data as computed for the year.

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**SCHEDULE II**

**VALUATIONAND QUALIFYING ACCOUNTS**

|                                                        | ** ** | **Balance at**   | ** ** | ** **    | ** ** | ** **     | ** ** | ** **                | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|---------------|------------|----------------|------------|---------------------------|------------|
| ** **                                             | ** ** | **Beginning of** | ** ** | ** **    | ** ** | ** **     | ** ** | **Balance at**       | ** ** |
| ** **                                             | ** ** | **Year**              | ** ** | **Provision** | ** ** | **Write-offs** | ** ** | **End of Year** | ** ** |
| **2005**                                               |       |                  |       |          |       |           |       |                      |       |
| Allowance for  Doubtful Accounts                       |       | $                     | 3,099,000  |          | $          | 1,186,000      |       | $                         | (711,000   | ) | $ | 3,574,000 |   |
| Valuation allowance on net deferred income tax  assets |       | $                     | 3,301,000  |          | $          | —         |       | $                         | (1,103,000 | ) | $ | 2,198,000 |   |
| **2004**                                               |       |                  |       |          |       |           |       |                      |       |
| Allowance for  Doubtful Accounts                       |       | $                     | 2,755,000  |          | $          | 1,193,000      |       | $                         | (849,000   | ) | $ | 3,099,000 |   |
| Valuation allowance on net deferred income tax  assets |       | $                     | 11,558,000 |          | $          | —         |       | $                         | (8,257,000 | ) | $ | 3,301,000 |   |
| **2003**                                               |       |                  |       |          |       |           |       |                      |       |
| Allowance for  Doubtful Accounts                       |       | $                     | 2,790,000  |          | $          | 1,150,000      |       | $                         | (1,185,000 | ) | $ | 2,755,000 |   |
| Valuation  allowance on net deferred income tax assets |       | $                     | 18,681,000 |          | $          | —         |       | $                         | (7,123,000 | ) | $ | 11,558,000 |   |

 

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**SIGNATURES**

Pursuantto the requirements of the Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this Report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                       | INTERNET  SECURITY SYSTEMS, INC. |
|-----------------------|----------------------------------|
|                  | By:                              | /s/ RAGHAVAN RAJAJI |
|                  |                             | Raghavan  Rajaji |   |
|                  |                             | *Senior Vice President and Chief Financial Officer* | * * |
| Dated: March 6,  2006 |                             |   |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BYTHESE PRESENTS, that each person whose signature appears below hereby severallyconstitutes and appoints, Thomas E. Noonan, Raghavan Rajaji and MaureenRichards, and each or any of them, his true and lawful attorney-in-fact andagent, each with the power of substitution and resubstitution, for him in anyand all capacities, to sign any and all amendments to this Annual Report (Form 10-K)and to file the same, with exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, hereby ratifying andconfirming all that each said attorney-in-fact and agent, or his substitute orsubstitutes, may lawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.
|                             | **Name** | ** **                                | ** ** |                    | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|-----------------------------|----------|-------------------------------------------|------------|--------------------|-----------|------------|------------|--|----------|------------|
| /s/ THOMAS E.  NOONAN       |     | Chairman,  President and Chief Executive  |       | March 6, 2006 |
| Thomas  E. Noonan           |     | (Principal Executive  Officer)            |       |               |
| /s/ CHRISTOPHER  W. KLAUS   |     | Secretary,  Security Adviser and Director |       | March 6, 2006 |
| Christopher  W. Klaus       |     |                                      |       |               |
| /s/ RAGHAVAN  RAJAJI        |     | Senior Vice  President and                |       | March 6, 2006 |
| Raghavan  Rajaji            |     | Chief Financial Officer                   |       |               |
| /s/ MAUREEN  RICHARDS       |     | Vice President,  Corporate Controller and |       | March 6, 2006 |
| Maureen  Richards           |     | (Principal Accounting  Officer)           |       |               |
| /s/ RICHARD S.  BODMAN      |     | Director                                  |       | March 6, 2006 |
| Richard  S. Bodman          |     |                                      |       |               |
| /s/ ROBERT E.  DAVOLI       |     | Director                                  |       | March 6, 2006 |
| Robert  E. Davoli           |     |                                      |       |               |
| /s/ SAM NUNN                |     | Director                                  |       | March 6, 2006 |
| Sam  Nunn                   |     |                                      |       |               |
| /s/ KEVIN J.  O’CONNOR |     | Director                                  |       | March 6, 2006 |
| Kevin  J. O’Connor     |     |                                      |       |               |
| /s/ DAVID N.  STROHM        |     | Director                                  |       | March 6, 2006 |
| David N. Strohm             |     |                                      |       |               |

 

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