##### Table of Contents









UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-K


|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|x          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934    
|           |  | For the fiscal year ended December 31, 2004                                                 
|           |  | OR                                                                                          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934
|           |  | For the transition period
    from                  to                                      



INTERNET SECURITY SYSTEMS, INC.




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

(404) 236-2600






Common Stock, $0.001 par value


Preferred Stock Purchase Rights


(Title of Class)






|                             | 
|---------------------------- | 
|Yes    x             No    o | 

x


x o






DOCUMENTS INCORPORATED BY REFERENCE












---

TABLE OF CONTENTS



|                                                        |                                                                                                                         |  |  |  |  |  |  | 
|------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                                                 
|                                                        | Item 1. Business                                                                                                       
|                                                        | Item 2. Properties                                                                                                     
|                                                        | Item 3. Legal Proceedings                                                                                              
|                                                        | Item 4. Submission of Matters to a Vote of Security Holders                                                            
|PART II                                                
|                                                        | Item 5. Market for Registrants Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities
|                                                        | Item 6. Selected Financial Data                                                                                        
|                                                        | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations                          
|                                                        | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                                                    
|                                                        | Item 8. Consolidated Financial Statements and Supplementary Data                                                       
|                                                        | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                           
|                                                        | Item 9A. Controls and Procedures                                                                                       
|                                                        | Item 9B. Other Information                                                                                             
|PART III                                               
|                                                        | Item 10. Directors and Executive Officers of the Registrant                                                            
|                                                        | Item 11. Executive Compensation                                                                                        
|                                                        | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                
|                                                        | Item 13. Certain Relationships and Related Transactions                                                                
|                                                        | Item 14. Principal Accountant Fees and Services                                                                        
|PART IV                                                
|                                                        | Item 15. Exhibits and Financial Statement Schedules                                                                    
|REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
|SCHEDULE II                                            
|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           



---



##### Table of Contents



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 Report on Form 10-K contains forward-looking
statements. Forward-looking statements 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-looking statements also include the
assumptions underlying or relating to any of the foregoing
statements. Our actual results could differ materially from
those anticipated in these forward-looking statements as a
result of various factors, including those set forth below under
the caption Risk Factors and those otherwise
described from time to time in our Securities and Exchange
Commission reports filed after this Form 10-K. All
forward-looking statements included in this Form 10-K are
based on information available to ISS on the date hereof. We
assume no obligation (except where required by law) to update
any forward-looking statements for any events or circumstances
occurring after the date of this Form 10-K.


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





PART I







|        |         
|------- | --------
|Item 1. | Business

Introduction




| |         
| | --------
| | Overview







| |                      
| | ---------------------
| | Products and Services



1



---



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tm






| |                     
| | --------------------
| | Intrusion Prevention





| |                    
| | -------------------
| | Intrusion Detection





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





| |                         
| | ------------------------
| | Vulnerability Assessment





| |                 
| | ----------------
| | Content Security





| |                    
| | -------------------
| | Security Management





| |                                
| | -------------------------------
| | Consumer/ Small Office Products



2



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| |                     
| | --------------------
| | Services and Support









| |                               
| | ------------------------------
| | Sales, Marketing and Customers







|              |  |      |    |   |      |  |    |      |  |  |    |  
|------------- |  | ---- | -- | - | ---- |  | -- | ---- |  |  | -- | -
|              |  | 2004 |    |   | 2003 |  |    | 2002 | 
|              |  |      |    |   |      |  |    |      | 
|Americas      |  |      | 64 | % |      |  | 69 | %    |  |  | 72 | %
|EMEA          |  |      | 22 |   |      |  | 19 |      |  |  | 15 |  
|Asia/ Pacific |  |      | 14 |   |      |  | 12 |      |  |  | 13 |  



3



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| |                 
| | ----------------
| | X-Force Research







| |                    
| | -------------------
| | Product Development







| |            
| | -----------
| | Competition



4



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Customers




Intellectual Property






Employees









|        |           
|------- | ----------
|Item 2. | Properties





5



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|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings








|        |                                                    
|------- | ---------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security Holders



6



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PART II







|        |                                                                                                                        
|------- | -----------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity and Related
    Stockholder Matters and Issuer Purchases of Equity
    Securities



|               |  |      |       |  |     |   |       | 
|-------------- |  | ---- | ----- |  | --- | - | ----- | 
|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 | 

|               |  |      |       |  |     |   |       | 
|-------------- |  | ---- | ----- |  | --- | - | ----- | 
|2003:          |  | High |       |  | Low |  
|               |  |      |       |  |     |  
|First Quarter  |  | $    | 24.20 |  |     | $ | 9.89  | 
|Second Quarter |  |      | 17.23 |  |     |   | 9.85  | 
|Third Quarter  |  |      | 15.69 |  |     |   | 10.84 | 
|Fourth Quarter |  |      | 19.07 |  |     |   | 12.41 | 









Purchases of Equity Securities




|                 |  |                  |         |  |                |                     |       |                 |                  |  |                    |  |  |   |            | 
|---------------- |  | ---------------- | ------- |  | -------------- | ------------------- | ----- | --------------- | ---------------- |  | ------------------ |  |  | - | ---------- | 
|                 |  |                  |         |  |                |                     |       | 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           | 
|                 |  |                  |         |  |                |                     |       |                 |                  |  |                    | 
|10/1/04-10/31/04 |  |                  |        |  |                |                     |      |                 |                  |  |                   |  |  | $ | 29,489,000 | 
|11/1/04-11/30/04 |  |                  | 160,000 |  |                | $                   | 23.65 |                 |                  |  | 160,000            |  |  | $ | 25,705,000 | 
|12/1/04-12/31/04 |  |                  | 110,000 |  |                | $                   | 24.29 |                 |                  |  | 110,000            |  |  | $ | 23,033,000 | 

7



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|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data



|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |         |         |         |   |        |         |         | 
|-------------------------------------------------------------------------- | ----------------------------------- | ------------------------------------------------ | ------- | ------- | ------- | - | ------ | ------- | ------- | - | ------ | ------- | ------- | ---- | ------- | ------- | ------- | - | ------ | ------- | ------- | 
|                                                                           |                                     | Year Ended December 31,                          |        
|                                                                           |                                     |                                                  |        
|                                                                           |                                     | 2004                                             |         |         | 2003    |   |        | 2002    |         |   | 2001   |         |         | 2000 |        
|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |        
|                                                                           |                                     | (amounts in thousands, except per share amounts) |        
|Consolidated Statement of Operations Data:                                 |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |         |         |         |   |        |        
|Revenues                                                                   |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |         |         |         |   |        |        
|                                                                           | Product licenses and sales          |                                                  | $       | 126,112 |         |   | $      | 107,117 |         |   | $      | 121,093 |         |      | $       | 122,385 |         |   | $      | 119,703 |        
|                                                                           | Subscriptions                       |                                                  |         | 140,693 |         |   |        | 112,855 |         |   |        | 92,945  |         |      |         | 66,687  |         |   |        | 41,706  |        
|                                                                           | Professional services               |                                                  |         | 23,088  |         |   |        | 25,809  |         |   |        | 29,247  |         |      |         | 34,487  |         |   |        | 33,566  |        
|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |        
|                                                                           |                                     | Total revenues                                   |         |         | 289,893 |   |        |         | 245,781 |   |        |         | 243,285 |      |         |         | 223,559 |   |        |         | 194,975 | 
|Cost of revenues                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |         |         |         |   |        |        
|                                                                           | Cost of licenses and sales          |                                                  |         | 22,388  |         |   |        | 9,528   |         |   |        | 6,688   |         |      |         | 13,439  |         |   |        | 22,653  |        
|                                                                           | Amortization of acquired technology |                                                  |         | 6,851   |         |   |        | 4,404   |         |   |        | 3,649   |         |      |         | 2,624   |         |   |        | 638     |        
|                                                                           | Cost of subscriptions and services  |                                                  |         | 48,999  |         |   |        | 48,686  |         |   |        | 51,133  |         |      |         | 50,708  |         |   |        | 36,771  |        
|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |        
|                                                                           |                                     | Total cost of revenues                           |         |         | 78,238  |   |        |         | 62,618  |   |        |         | 61,470  |      |         |         | 66,771  |   |        |         | 60,062  | 
|Research and development                                                   |                                     |                                                  | 42,976  |         |         |   | 41,843 |         |         |   | 35,280 |         |         |      | 35,413  |         |         |   | 31,316 |        
|Sales and marketing                                                        |                                     |                                                  | 100,966 |         |         |   | 87,452 |         |         |   | 93,679 |         |         |      | 92,001  |         |         |   | 68,032 |        
|General and administrative                                                 |                                     |                                                  | 27,568  |         |         |   | 22,661 |         |         |   | 24,271 |         |         |      | 20,442  |         |         |   | 14,481 |        
|Write-off of lease obligation                                              |                                     |                                                  |        |         |         |   |       |         |         |   |       |         |         |      | 1,072   |         |         |   |       |        
|Charge for in-process research and development                             |                                     |                                                  |        |         |         |   |       |         |         |   | 18,537 |         |         |      | 2,910   |         |         |   |       |        
|Amortization of goodwill                                                   |                                     |                                                  |        |         |         |   |       |         |         |   |       |         |         |      | 26,505  |         |         |   | 479    |        
|Amortization and write-off of intangibles and stock-based
    compensation |                                     |                                                  | 402     |         |         |   | 1,611  |         |         |   | 2,025  |         |         |      | 2,603   |         |         |   | 36     |        
|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |        
|Operating income (loss)                                                    |                                     |                                                  | 39,743  |         |         |   | 29,596 |         |         |   | 8,023  |         |         |      | (24,158 | )       |         |   | 20,569 |        
|Other income (expense), net                                                |                                     |                                                  | (866    | )       |         |   | (1,560 | )       |         |   | 990    |         |         |      | (68     | )       |         |   |       |        
|Gain on issuance of subsidiary stock                                       |                                     |                                                  | 292     |         |         |   | 249    |         |         |   | 2,600  |         |         |      | 15,200  |         |         |   |       |        
|Net income (loss)                                                          |                                     | $                                                | 26,293  |         |         | $ | 19,737 |         |         | $ | 1,779  |         |         | $    | (15,458 | )       |         | $ | 18,315 |        
|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |        
|Diluted net income (loss) per share                                        |                                     | $                                                | 0.54    |         |         | $ | 0.39   |         |         | $ | 0.04   |         |         | $    | (0.34   | )       |         | $ | 0.41   |        
|                                                                           |                                     |                                                  |         |         |         |   |        |         |         |   |        |         |         |      |        

|                                        |  |                        |         |  |      |   |         |      |  |   |         |  |  |      |         |  |  |   |         | 
|--------------------------------------- |  | ---------------------- | ------- |  | ---- | - | ------- | ---- |  | - | ------- |  |  | ---- | ------- |  |  | - | ------- | 
|                                        |  | December 31,           |        
|                                        |  |                        |        
|                                        |  | 2004                   |         |  | 2003 |   |         | 2002 |  |   | 2001    |  |  | 2000 |        
|                                        |  |                        |         |  |      |   |         |      |  |   |         |  |  |      |        
|                                        |  | (amounts in thousands) |        
|Consolidated Balance Sheet Data:        |  |                        |         |  |      |   |         |      |  |   |         |  |  |      |         |  |  |   |         | 
|Cash and marketable securities          |  | $                      | 211,049 |  |      | $ | 238,181 |      |  | $ | 202,316 |  |  | $    | 163,167 |  |  | $ | 132,148 | 
|Working capital                         |  |                        | 199,241 |  |      |   | 229,743 |      |  |   | 187,387 |  |  |      | 149,080 |  |  |   | 145,133 | 
|Goodwill, less accumulated amortization |  |                        | 224,065 |  |      |   | 201,303 |      |  |   | 200,464 |  |  |      | 197,060 |  |  |   | 3,167   | 
|Total assets                            |  |                        | 598,902 |  |      |   | 581,282 |      |  |   | 546,568 |  |  |      | 500,984 |  |  |   | 240,240 | 
|Stockholders equity                    |  |                        | 481,580 |  |      |   | 486,343 |      |  |   | 464,556 |  |  |      | 426,935 |  |  |   | 188,389 | 

8



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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis of Financial
    Condition and Results of Operations

The following Managements Discussion and Analysis of
Financial Condition and Results of Operations should be read in
conjunction with the Consolidated Financial Statements and
related Notes thereto included elsewhere in this Form 10-K.
Except for the historical financial information, many of the
matters discussed in this Item 7 may be considered
forward-looking statements. Such forward-looking
statements are not guarantees of future performance and involve
a number of risks and uncertainties. Many of the risks and
uncertainties are described below under the caption Risk
Factors.


Overview












Critical Accounting Policies




9



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| |                    
| | -------------------
| | Revenue recognition





| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Product licenses and sales, which include revenue from
    sales of perpetual software licenses and products;                                               
|
| |  | Subscription revenues, which include product support and
    content updates, term licenses, subscription licenses and
    managed service arrangements; and
|
| |  | Professional services revenues, which includes fee-based
    service engagements and training.                                                              

Software Revenue
Recognition, Software
Revenue Recognition with Respect to Certain Transactions,




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



| |                           
| | --------------------------
| | Product licenses and sales









| |                      
| | ---------------------
| | Subscription revenues





10



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| |                               
| | ------------------------------
| | Professional services revenues





| |                               
| | ------------------------------
| | Multiple elements arrangements





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





| |                                
| | -------------------------------
| | Allowance for doubtful accounts







11



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| |                                                                      
| | ---------------------------------------------------------------------
| | Impairment of goodwill and other long-lived and intangible
    assets







| |                                     
| | ------------------------------------
| | Recently Issued Accounting Standards

Share-Based Payment, Accounting for
Stock-Based Compensation. Accounting for Stock Issued to
Employees.




Acquisitions




12



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13



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Results of Operations




|                                                                           |                                         |                          |    |    |      |  |    |      |     |  |    |    |     | 
|-------------------------------------------------------------------------- | --------------------------------------- | ------------------------ | -- | -- | ---- |  | -- | ---- | --- |  | -- | -- | --- | 
|                                                                           |                                         | Year Ended December 31,  |   
|                                                                           |                                         |                          |   
|                                                                           |                                         | 2004                     |    |    | 2003 |  |    | 2002 |    
|                                                                           |                                         |                          |    |    |      |  |    |      |    
|Consolidated Statements of Operations Data:                                |                                         |                          |    |    |      |  |    |      |     |  |    |   
|                                                                           | Product licenses and sales              |                          |    | 43 | %    |  |    | 44   | %   |  |    | 50 | %  
|                                                                           | Subscriptions                           |                          |    | 49 |      |  |    | 46   |     |  |    | 38 |    
|                                                                           | Professional services                   |                          |    | 8  |      |  |    | 10   |     |  |    | 12 |    
|                                                                           |                                         |                          |    |    |      |  |    |      |    
|                                                                           |                                         | Total revenues           |    |    | 100  |  |    |      | 100 |  |    |    | 100 | 
|                                                                           |                                         |                          |    |    |      |  |    |      |    
|Cost of revenues:                                                          |                                         |                          |    |    |      |  |    |      |     |  |    |   
|                                                                           | Product licenses and sales              |                          |    | 8  |      |  |    | 4    |     |  |    | 3  |    
|                                                                           | Amortization of acquired technology     |                          |    | 2  |      |  |    | 1    |     |  |    | 1  |    
|                                                                           | Subscriptions and professional services |                          |    | 17 |      |  |    | 20   |     |  |    | 21 |    
|                                                                           |                                         |                          |    |    |      |  |    |      |    
|                                                                           |                                         | Total cost of revenues   |    |    | 27   |  |    |      | 25  |  |    |    | 25  | 
|Research and development                                                   |                                         |                          | 15 |    |      |  | 17 |      |     |  | 15 |   
|Sales and marketing                                                        |                                         |                          | 35 |    |      |  | 36 |      |     |  | 39 |   
|General and administrative                                                 |                                         |                          | 9  |    |      |  | 9  |      |     |  | 10 |   
|Charge for in-process research and development                             |                                         |                          |   |    |      |  |   |      |     |  | 8  |   
|Amortization and write-off of intangibles and stock based
    compensation |                                         |                          |   |    |      |  | 1  |      |     |  | 1  |   
|                                                                           |                                         | Total costs and expenses |    |    | 86   |  |    |      | 88  |  |    |    | 98  | 
|                                                                           |                                         |                          |    |    |      |  |    |      |    
|Operating income                                                           |                                         |                          | 14 | %  |      |  | 12 | %    |     |  | 2  | % 

Revenues




| |                           
| | --------------------------
| | Product licenses and sales







14



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| |              
| | -------------
| | Subscriptions









| |                      
| | ---------------------
| | Professional services





| |                   
| | ------------------
| | Geographic regions



|              |  |      |    |   |      |  |    |      |  |  |    |  
|------------- |  | ---- | -- | - | ---- |  | -- | ---- |  |  | -- | -
|              |  | 2004 |    |   | 2003 |  |    | 2002 | 
|              |  |      |    |   |      |  |    |      | 
|Americas      |  |      | 64 | % |      |  | 69 | %    |  |  | 72 | %
|EMEA          |  |      | 22 | % |      |  | 19 | %    |  |  | 15 | %
|Asia/ Pacific |  |      | 14 | % |      |  | 12 | %    |  |  | 13 | %



Costs and Expenses




| |          
| | ---------
| | Personnel



15



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| |                                   
| | ----------------------------------
| | Cost of product licenses and sales







| |                                                
| | -----------------------------------------------
| | Cost of subscriptions and professional services









| |                         
| | ------------------------
| | Research and development



16



---



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| |                    
| | -------------------
| | Sales and marketing











| |                           
| | --------------------------
| | General and administrative





17



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| |                                               
| | ----------------------------------------------
| | Charge for in-process research and development





| |             
| | ------------
| | Amortization





| |                
| | ---------------
| | Interest income





| |                            
| | ---------------------------
| | Other income (expense), net





| |                           
| | --------------------------
| | Provision for income taxes





18



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Liquidity and Capital Resources


















| |                               
| | ------------------------------
| | Off-Balance Sheet Arrangements



19



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| |                        
| | -----------------------
| | Contractual Commitments



|                                   |  |       |        |                        |                  |   |        |           |  |   |           |  |  |               |        |  |  |   |        | 
|---------------------------------- |  | ----- | ------ | ---------------------- | ---------------- | - | ------ | --------- |  | - | --------- |  |  | ------------- | ------ |  |  | - | ------ | 
|                                   |  |       |        | Payments Due by Period |                 
|                                   |  |       |        |                        |                 
|                                   |  | Total |        |                        | Less than 1 Year |   |        | 1-3 Years |  |   | 3-5 Years |  |  | After 5 Years |       
|                                   |  |       |        |                        |                  |   |        |           |  |   |           |  |  |               |       
|Operating lease obligations        |  | $     | 79,377 |                        |                  | $ | 13,366 |           |  | $ | 22,192    |  |  | $             | 16,915 |  |  | $ | 26,904 | 
|Other                              |  |       | 484    |                        |                  |   | 484    |           |  |   |          |  |  |               |       |  |  |   |       | 
|                                   |  |       |        |                        |                  |   |        |           |  |   |           |  |  |               |       
|Total contractual cash obligations |  | $     | 79,861 |                        |                  | $ | 13,850 |           |  | $ | 22,192    |  |  | $             | 16,915 |  |  | $ | 26,904 | 
|                                   |  |       |        |                        |                  |   |        |           |  |   |           |  |  |               |       



Risk Factors






| |                                        
| | ---------------------------------------
| | We Operate in a Rapidly Evolving Market





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







| |                                                                     
| | --------------------------------------------------------------------
| | Our Future Operating Results Will Likely Fluctuate
    Significantly





| |   |                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------
| |  | the extent to which the public perceives that unauthorized
    access to and use of online information are threats to network
    security;
|
| |  | customer budgets;                                                                                                                          

20



---



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| |   |                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the mix of product sales among the various products offered
    by ISS and whether revenue is recognized upon sale or
    deferred to subsequent periods;
|
| |  | the volume and timing of orders, including seasonal trends in
    customer purchasing;                                                                   
|
| |  | our ability to develop new and enhanced product and managed
    service offerings;                                                                       
|
| |  | the introduction and acceptance rate of ISS branded
    appliances, including increased cost of goods sold;                                              
|
| |  | our ability to accurately forecast and produce demanded
    quantities of our appliance products and models;                                             
|
| |  | availability of component parts of appliance products and
    reliance on contract manufacturers to produce such products;                               
|
| |  | our ability to provide scalable managed services offerings in a
    cost effective manner;                                                               
|
| |  | foreign currency exchange rates that affect our international
    operations;                                                                            
|
| |  | product and price competition in our markets; and                                                                                                        
|
| |  | general economic conditions, both domestically and in our
    foreign markets.                                                                           









| |                                                      
| | -----------------------------------------------------
| | Dependence on Third Party Suppliers and Manufacturers



21



---



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| |                                          
| | -----------------------------------------
| | We Face Intense Competition in Our Market





| |   |                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | large companies, including Symantec Corp., Cisco Systems, Inc.,
    Juniper Networks, Inc., and McAfee, Inc., that sell competitive
    products and offerings, as well as other large software
    companies that have the technical capability and resources to
    develop competitive products;
|
| |  | software or hardware network infrastructure companies like Cisco
    Systems, Inc. and Juniper Networks, Inc. that could integrate
    features that are similar to our products into their own
    products;                                                                                      
|
| |  | smaller software companies offering relatively limited
    applications for network and Internet security; and                                                                                                                                                                                     
|
| |  | small and large companies with competitive offerings to
    components of our managed services offerings.                                                                                                                                                                                          











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





| |   |                                                                                      
| | - | -------------------------------------------------------------------------------------
| |  | the extent to which businesses and others seek to establish more
    secure networks;
|
| |  | the extent to which hackers and others seek to compromise secure
    systems;        

22



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| |   |                                                                 
| | - | ----------------------------------------------------------------
| |  | evolving computer hardware and software standards;              
|
| |  | changing customer requirements; and                             
|
| |  | frequent introductions of new products and product enhancements.









| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | Undetected Product Errors or Defects Could Result in Loss of
    Revenues, Delayed Market Acceptance and Claims Against Us









| |   |                                                       
| | - | ------------------------------------------------------
| |  | failure to achieve market acceptance;                 
|
| |  | loss of customers;                                    
|
| |  | loss of or delay in revenues and loss of market share;
|
| |  | diversion of development resources;                   
|
| |  | increased service and warranty costs;                 
|
| |  | legal actions by our customers; and                   
|
| |  | increased insurance costs.                            

23



---



##### Table of Contents





| |                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------
| | Our Products are Complex and Are Operated in a Wide Variety
    of Computer Configurations, Which Could Result in Errors or
    Product Failures







| |                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------
| | We Might Have to Defend Lawsuits or Pay Damages in Connection
    With Any Alleged or Actual Failure of Our Products and
    Services





| |                                            
| | -------------------------------------------
| | Risks Associated with Our Global Operations





| |   |                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the difficulty in managing an organization spread over various
    countries located across the world;                                           
|
| |  | compliance with, and unexpected changes in, a wide range of
    complex regulatory requirements in countries where we do
    business;           
|
| |  | duties and tariffs imposed on importation of our products in
    other jurisdictions where other manufacturers may not bear those
    same costs;
|
| |  | increased financial accounting and reporting burdens;                                                                                            
|
| |  | potentially adverse tax consequences;                                                                                                            

24



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| |   |                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | fluctuations in foreign currency exchange rates resulting in
    losses or gains from transactions and expenses denominated in
    foreign currencies;                  
|
| |  | reduced protection for intellectual property rights in some
    countries;                                                                                              
|
| |  | reduced protection for enforcement of creditor and contractual
    rights in some countries; and                                                                        
|
| |  | import and export license requirements and restrictions on the
    import and export of certain technology, especially encryption
    technology and trade restrictions.





| |                                                                   
| | ------------------------------------------------------------------
| | Our Networks, Products and Services May be Targeted by
    Hackers





| |                                            
| | -------------------------------------------
| | We Must Successfully Integrate Acquisitions





| |                                                   
| | --------------------------------------------------
| | Our Proprietary Rights May be Difficult to Enforce



25



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| |                                                                 
| | ----------------------------------------------------------------
| | We May Be Found to Infringe the Proprietary Rights of
    Others





| |                                                                                  
| | ---------------------------------------------------------------------------------
| | We Must Continue to Attract and Retain Personnel in a
    Competitive Marketplace





| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | Some Provisions in the ISS Certificate of Incorporation and
    Bylaws Make a Takeover of ISS Difficult





| |   |                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | establish a classified board of directors;                                                                                                                                                                                                                        
|
| |  | create preferred stock purchase rights that grant to holders of
    common stock the right to purchase shares of Series A
    Junior Preferred Stock in the event that a third party acquires
    20% or more of the voting power of our outstanding common stock;
|
| |  | prohibit the right of our stockholders to act by written consent;                                                                                                                                                                                                 
|
| |  | limit calling special meetings of stockholders; and                                                                                                                                                                                                               
|
| |  | impose a requirement that holders of
    662/3%
    of the outstanding shares of common stock are required to amend
    the provisions relating to the classification of our board of
    directors and action by written consent of stockholders.                






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures About Market
    Risk

Interest Rate Sensitivity




26



---



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Risk Associated with Foreign Exchange Rates








27



---



##### Table of Contents








|        |                                                             
|------- | ------------------------------------------------------------
|Item 8. | Consolidated Financial Statements and Supplementary
    Data

|                                                                                                         |  |      |    | 
|-------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                                                                                         |  | Page |   
|                                                                                                         |  |      |   
|Internet Security Systems, Inc.                                                                          |  |      |    | 
|Report of Independent Registered Public Accounting Firm
    Regarding Financial Statements               |  |      | 34 | 
|Consolidated Balance Sheets as of December 31, 2004 and 2003                                             |  |      | 35 | 
|Consolidated Statements of Operations for the Years Ended
    December 31, 2004, 2003 and 2002           |  |      | 36 | 
|Consolidated Statements of Stockholders Equity for the
    Years Ended December 31, 2004, 2003 and 2002 |  |      | 37 | 
|Consolidated Statements of Cash Flows for the Years Ended
    December 31, 2004, 2003 and 2002           |  |      | 38 | 
|Notes to Consolidated Financial Statements                                                               |  |      | 39 | 
|2. Consolidated Financial Statement SchedulesSchedule II  Valuation and Qualifying
    Accounts         |  |      | 60 | 








|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure








|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures



Disclosure Controls and Procedures








Management Report on Internal Control Over Financial
Reporting






28



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Internal
Control  Integrated Framework.










Remediation Steps to Address the Material Weakness








| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | additional training on complex revenue recognition principles
    for our contract administration and accounting staff during the
    quarter ended March 31, 2005 and on an ongoing basis; and
|
| |  | establishing an additional level of management review for any
    contracts that exceed specific materiality thresholds.                                                                       

Changes in Internal Control Over Financial Reporting




29



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
















30



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| |                      
| | ---------------------
| | /s/ Ernst & Young LLP








Item 9B.Other
Information




31



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##### Table of Contents






PART III







|         |                                                   
|-------- | --------------------------------------------------
|Item 10. | Directors and Executive Officers of the Registrant

Directors and Executive Officers




Code of Conduct and Code of Ethics for Financial
Professionals









|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation








|         |                                                                                                   
|-------- | --------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial Owners and
    Management and Related Stockholder Matters








|         |                                               
|-------- | ----------------------------------------------
|Item 13. | Certain Relationships and Related Transactions








|         |                                       
|-------- | --------------------------------------
|Item 14. | Principal Accountant Fees and Services



32



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##### Table of Contents






PART IV







|         |                                           
|-------- | ------------------------------------------
|Item 15. | Exhibits and Financial Statement Schedules





| |                                                                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. Consolidated Financial Statements. See Index to
    Financial Statements on page 27                                                                                                                                                                                                                                                           
|
| | 2. Financial Statement Schedules. See Index to
    Financial Statements on page 27                                                                                                                                                                                                                                                               
|
| | 3. Exhibits. The exhibits to this Annual Report on
    Form 10-K have been included only with the copy of this
    Annual Report on Form 10-K filed with the Securities and
    Exchange Commission. Copies of individual exhibits will be
    furnished to stockholders upon written request to the Company
    and payment of a reasonable fee.

|        |    |     |  |                        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------- | -- | --- |  | ---------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |     |  |                       
|Number  |    |     |  | Description of Exhibit
|        |    |     |  |                       
|        | 2  | .1  |  |                       |  | Agreement and Plan of Merger by and among Internet Security
    Systems, Inc., ISS Acquisition Corp. II, Network ICE
    Corporation and certain selling shareholders of Network ICE
    Corporation (filed as Exhibit 2.1 to the Companys
    Quarterly Report on Form 10-Q dated May 11, 2001 and
    incorporated by reference herein).                                                                                                                              
|        | 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).                                                                                                                                                                                                                                                
|        | 10 | .1  |  |                       |  | Stock Exchange Agreement dated December 9, 1997 (filed as
    Exhibit 10.4 to the Form S-1 and incorporated by
    reference herein).                                                                                                                                                                                                                                                                                                                                    
|        | 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).                                                                                                                                                                                                                                                                

33



---



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|              |    |       |  |                            |  |                                                                                                                                                                                                                                                                                                          
|------------- | -- | ----- |  | -------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |    |       |  | Description of
    Exhibit
|              |    |       |  |                            |  |                                                                                                                                                                                                                                                                                                          
|              | 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                                                                                                                                                                           






|   |  |                                                                                                                                            
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|*  |  | Identifies those filed exhibits with this Form 10-K.                                                                                       
|  
|+  |  | Management contract or compensatory plan                                                                                                   
|  
|** |  | Data required by SFAS No. 128, Earnings Per
    Share, is provided in Note 4 to the consolidated
    financial statements in this report.

34



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
















| |                      
| | ---------------------
| | /s/ Ernst & Young LLP





35



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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC.


CONSOLIDATED BALANCE SHEETS


|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |             |             |             |             |             | 
|-------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------- | -------------------- | ------------------------------------------ | ----------- | ----------- | ----------- | ----------- | ----------- | ----------- | ----------- | 
|                                                                                                                                             |                                                                                                            | December 31,         |                                           
|                                                                                                                                             |                                                                                                            |                      |                                           
|                                                                                                                                             |                                                                                                            | 2004                 |                                            |             | 2003        |            
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|ASSETS                                                                                                                                      
|Current assets:                                                                                                                              |                                                                                                            |                      |                                            |             |             |             |             |            
|                                                                                                                                             | Cash and cash equivalents                                                                                  |                      | $                                          | 140,148,000 |             |             | $           | 192,231,000 |            
|                                                                                                                                             | Marketable securities                                                                                      |                      |                                            | 70,901,000  |             |             |             | 45,950,000  |            
|                                                                                                                                             | Accounts receivable, less allowance for doubtful accounts of
    $3,099,000 in 2004 and $2,755,000 in 2003 |                      |                                            | 75,353,000  |             |             |             | 66,588,000  |            
|                                                                                                                                             | Inventory                                                                                                  |                      |                                            | 2,506,000   |             |             |             | 750,000     |            
|                                                                                                                                             | Prepaid expenses and other current assets                                                                  |                      |                                            | 12,728,000  |             |             |             | 10,732,000  |            
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            | Total current assets |                                            |             | 301,636,000 |             |             |             | 316,251,000 |            
|Property and equipment:                                                                                                                      |                                                                                                            |                      |                                            |             |             |             |             |            
|                                                                                                                                             | Computer equipment and software                                                                            |                      |                                            | 52,412,000  |             |             |             | 45,261,000  |            
|                                                                                                                                             | Office furniture and equipment                                                                             |                      |                                            | 18,091,000  |             |             |             | 21,311,000  |            
|                                                                                                                                             | Leasehold improvements                                                                                     |                      |                                            | 21,098,000  |             |             |             | 21,674,000  |            
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            |                      | 91,601,000                                 |             |             |             | 88,246,000  |            
|                                                                                                                                             | Less accumulated depreciation                                                                              |                      |                                            | 57,161,000  |             |             |             | 52,427,000  |            
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            |                      | 34,440,000                                 |             |             |             | 35,819,000  |            
|Restricted cash and marketable securities                                                                                                    |                                                                                                            |                      | 10,300,000                                 |             |             |             | 12,760,000  |            
|Goodwill, less accumulated amortization of $27,381,000                                                                                       |                                                                                                            |                      | 224,065,000                                |             |             |             | 201,303,000 |            
|Other intangible assets, less accumulated amortization of
    $20,951,000 in 2004 and $13,499,000 in 2003                                    |                                                                                                            |                      | 19,763,000                                 |             |             |             | 9,728,000   |            
|Other assets                                                                                                                                 |                                                                                                            |                      | 8,698,000                                  |             |             |             | 5,421,000   |            
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            |                      | Total assets                               |             | $           | 598,902,000 |             |             | $           | 581,282,000 | 
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                        
|Current liabilities:                                                                                                                         |                                                                                                            |                      |                                            |             |             |             |             |            
|                                                                                                                                             | Accounts payable                                                                                           |                      | $                                          | 6,911,000   |             |             | $           | 5,145,000   |            
|                                                                                                                                             | Accrued expenses                                                                                           |                      |                                            | 25,238,000  |             |             |             | 26,092,000  |            
|                                                                                                                                             | Deferred revenues                                                                                          |                      |                                            | 70,246,000  |             |             |             | 55,271,000  |            
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            |                      | Total current liabilities                  |             |             | 102,395,000 |             |             |             | 86,508,000  | 
|Long-term deferred revenues                                                                                                                  |                                                                                                            |                      | 8,432,000                                  |             |             |             | 5,858,000   |            
|Other non-current liabilities                                                                                                                |                                                                                                            |                      | 6,495,000                                  |             |             |             | 2,573,000   |            
|Commitments and contingencies                                                                                                                |                                                                                                            |                      |                                            |             |             |             |             |            
|Stockholders equity:                                                                                                                        |                                                                                                            |                      |                                            |             |             |             |             |            
|Preferred stock; $.001 par value; 20,000,000 shares
    authorized, none issued or outstanding                                               |                                                                                                            |                      |                                           |             |             |             |            |            
|Common stock; $.001 par value; 120,000,000 shares
    authorized, 50,754,000 and 49,841,000 shares issued in 2004
    and 2003, respectively |                                                                                                            |                      | 51,000                                     |             |             |             | 50,000      |            
|Additional paid-in capital                                                                                                                   |                                                                                                            |                      | 499,534,000                                |             |             |             | 475,062,000 |            
|Deferred compensation                                                                                                                        |                                                                                                            |                      | (3,197,000                                 | )           |             |             | (92,000     | )          
|Accumulated other comprehensive income                                                                                                       |                                                                                                            |                      | 11,041,000                                 |             |             |             | 7,452,000   |            
|Retained earnings                                                                                                                            |                                                                                                            |                      | 48,544,000                                 |             |             |             | 22,251,000  |            
|Treasury stock, at cost (4,871,000 and 1,310,000 shares in
    2004 and 2003, respectively)                                                  |                                                                                                            |                      | (74,393,000                                | )           |             |             | (18,380,000 | )          
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            |                      | Total stockholders equity                 |             |             | 481,580,000 |             |             |             | 486,343,000 | 
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            
|                                                                                                                                             |                                                                                                            |                      | Total liabilities and stockholders equity |             | $           | 598,902,000 |             |             | $           | 581,282,000 | 
|                                                                                                                                             |                                                                                                            |                      |                                            |             |             |            



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INTERNET SECURITY SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF OPERATIONS


|                                               |                                                                                  |                                         |             |             |            |   |             |             |            |   |             |             |            | 
|---------------------------------------------- | -------------------------------------------------------------------------------- | --------------------------------------- | ----------- | ----------- | ---------- | - | ----------- | ----------- | ---------- | - | ----------- | ----------- | ---------- | 
|                                               |                                                                                  | Year Ended December 31,                 |            
|                                               |                                                                                  |                                         |            
|                                               |                                                                                  | 2004                                    |             |             | 2003       |   |             | 2002        |           
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Revenues:                                      |                                                                                  |                                         |             |             |            |   |             |             |            |   |             |            
|                                               | Product licenses and sales                                                       |                                         | $           | 126,112,000 |            |   | $           | 107,117,000 |            |   | $           | 121,093,000 |           
|                                               | Subscriptions                                                                    |                                         |             | 140,693,000 |            |   |             | 112,855,000 |            |   |             | 92,945,000  |           
|                                               | Professional services                                                            |                                         |             | 23,088,000  |            |   |             | 25,809,000  |            |   |             | 29,247,000  |           
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|                                               |                                                                                  |                                         | 289,893,000 |             |            |   | 245,781,000 |             |            |   | 243,285,000 |            
|Costs and expenses:                            |                                                                                  |                                         |             |             |            |   |             |             |            |   |             |            
|                                               | Cost of revenues:                                                                |                                         |             |             |            |   |             |             |            |   |             |             |           
|                                               |                                                                                  | Product licenses and sales              |             |             | 22,388,000 |   |             |             | 9,528,000  |   |             |             | 6,688,000  | 
|                                               |                                                                                  | Amortization of acquired technology     |             |             | 6,851,000  |   |             |             | 4,404,000  |   |             |             | 3,649,000  | 
|                                               |                                                                                  | Subscriptions and professional services |             |             | 48,999,000 |   |             |             | 48,686,000 |   |             |             | 51,133,000 | 
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|                                               |                                                                                  | Total cost of revenues                  |             |             | 78,238,000 |   |             |             | 62,618,000 |   |             |             | 61,470,000 | 
|                                               | Research and development                                                         |                                         |             | 42,976,000  |            |   |             | 41,843,000  |            |   |             | 35,280,000  |           
|                                               | Sales and marketing                                                              |                                         |             | 100,966,000 |            |   |             | 87,452,000  |            |   |             | 93,679,000  |           
|                                               | General and administrative                                                       |                                         |             | 27,568,000  |            |   |             | 22,661,000  |            |   |             | 24,271,000  |           
|                                               | Charge for in-process research and development                                   |                                         |             |            |            |   |             |            |            |   |             | 18,537,000  |           
|                                               | Amortization and write-off of other intangibles and stock-based
    compensation |                                         |             | 402,000     |            |   |             | 1,611,000   |            |   |             | 2,025,000   |           
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|                                               |                                                                                  |                                         | 250,150,000 |             |            |   | 216,185,000 |             |            |   | 235,262,000 |            
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Operating income                               |                                                                                  |                                         | 39,743,000  |             |            |   | 29,596,000  |             |            |   | 8,023,000   |            
|Interest income                                |                                                                                  |                                         | 2,517,000   |             |            |   | 2,683,000   |             |            |   | 3,242,000   |            
|Other income (expense), net                    |                                                                                  |                                         | (866,000    | )           |            |   | (1,560,000  | )           |            |   | 990,000     |            
|Gain on issuance of subsidiary stock           |                                                                                  |                                         | 292,000     |             |            |   | 249,000     |             |            |   | 2,600,000   |            
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Income before income taxes                     |                                                                                  |                                         | 41,686,000  |             |            |   | 30,968,000  |             |            |   | 14,855,000  |            
|Provision for income taxes                     |                                                                                  |                                         | 15,393,000  |             |            |   | 11,231,000  |             |            |   | 13,076,000  |            
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Net income                                     |                                                                                  | $                                       | 26,293,000  |             |            | $ | 19,737,000  |             |            | $ | 1,779,000   |            
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Basic net income per share of Common Stock     |                                                                                  | $                                       | 0.56        |             |            | $ | 0.40        |             |            | $ | 0.04        |            
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Diluted net income per share of Common Stock   |                                                                                  | $                                       | 0.54        |             |            | $ | 0.39        |             |            | $ | 0.04        |            
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|Weighted average shares and equivalent shares: |                                                                                  |                                         |             |             |            |   |             |             |            |   |             |            
|                                               | Basic                                                                            |                                         |             | 46,985,000  |            |   |             | 49,155,000  |            |   |             | 48,456,000  |           
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           
|                                               | Diluted                                                                          |                                         |             | 48,458,000  |            |   |             | 50,018,000  |            |   |             | 49,158,000  |           
|                                               |                                                                                  |                                         |             |             |            |   |             |             |           



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INTERNET SECURITY SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY


|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             |             |            | 
|---------------------------- | --------------------------------------------------------------------------------------------------- | ---------------------------- | ---------- | ------- | ---------- | - | ------ | -------- | ----- | ------------- | ------------ | ---------- | ---------- | ------------ | ---------- | --------- | ---------- | ------------- | ---------- | ------ | --------- | - | ------------- |  | ---------- | ------ | ----------- | ----------- | - | - | ---------- | - | ---------- | - | ----------- | ----------- | ---------- | 
|                             |                                                                                                     |                              |            |         |            |   |        |          |       | Retained      |              |            |            |              |            |           |           
|                             |                                                                                                     | Common Stock                 |            |         | Additional |   |        |          |       | Comprehensive |              |            | Earnings   |              |            |           |            | Comprehensive |            |        | Total     |  
|                             |                                                                                                     |                              |            |         | Paid-In    |   |        | Deferred |       |               | Income       |            |            | (Accumulated |            |           | Treasury   |               |            | Income |           |   | Stockholders | 
|                             |                                                                                                     | Shares                       |            |         | Amount     |   |        | Capital  |       |               | Compensation |            |            | (Loss)       |            |           | Deficit)   |               |            | Stock  |           |   | (Loss)        |  |            | Equity |            
|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |            
|Balance at December 31, 2001 |                                                                                                     |                              | 47,871,000 |         |            | $ | 48,000 |          |       | $             | 430,449,000  |            |            | $            | (1,985,000 | )         |            | $             | (2,312,000 | )      |           | $ | 735,000       |  |            | $      |            |             |   |   |            |   |            | $ | 426,935,000 |            
|                             | Comprehensive income:                                                                               |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             |             |           
|                             |                                                                                                     | Net income                   |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  | 1,779,000  |        |             |             |   |   |            | $ | 1,779,000  |   |             |             | 1,779,000  | 
|                             |                                                                                                     | Translation adjustment       |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        | 3,261,000 |   |               |  |            |        |             |             |   |   |            |   | 3,261,000  |   |             |             | 3,261,000  | 
|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |            
|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   | $ | 5,040,000  |   |            |   |             |            
|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |            
|                             | Issuance of Common Stock:                                                                           |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             |             |           
|                             |                                                                                                     | Exercise of stock options    |            |         | 586,000    |   |        |          | 1,000 |               |              |            | 3,696,000  |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             |             | 3,697,000  | 
|                             |                                                                                                     | Employee stock purchase plan |            |         | 126,000    |   |        |          |       |               |              |            | 2,095,000  |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             |             | 2,095,000  | 
|                             |                                                                                                     | Acquisition                  |            |         | 966,000    |   |        |          | 1,000 |               |              |            | 16,857,000 |              |            |           | (153,000   | )             |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             |             | 16,705,000 | 
|                             | Amortization of deferred compensation                                                               |                              |            |         |            |   |        |          |       |               |              |            |            |              |            | 1,094,000 |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             | 1,094,000   |           
|                             | Adjustment to deferred compensation and repurchase of unvested
    shares from terminated employees |                              |            | (5,000  | )          |   |        |          |       |               |              | (352,000   | )          |              |            | 342,000   |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             | (10,000     | )         
|                             | Tax benefit related to employee options                                                             |                              |            |         |            |   |        |          |       |               |              | 11,034,000 |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             | 11,034,000  |           
|                             | Purchases of treasury stock (133,000 shares)                                                        |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             | (2,034,000  | ) |   |            |   |            |   |             | (2,034,000  | )         
|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |            
|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  | 
|                             | Amortization of deferred compensation                                                               |                              |            |         |            |   |        |          |       |               |              |            |            |              |            | 359,000   |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             | 359,000     |           
|                             | Restricted stock awards                                                                             |                              |            | 13,000  |            |   |        |          |       |               |              | 213,000    |            |              |            |           |            |               |            |        |           |   |               |  |            |        |             |             |   |   |            |   |            |   |             | 213,000     |           
|                             | 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 award       |            |         | 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 |            
|                             |                                                                                                     |                              |            |         |            |   |        |          |       |               |              |            |            |              |            |           |            |               |            |        |           |   |               |  |            |        |            



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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |            |             |             |            |            |           |             |  
|------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------- | ------------------------------------- | --------------------------------------------------- | --------------------------------------------------- | ---------- | ----------- | ----------- | ---------- | ---------- | ----------- | ----------- | ---------- | ---------- | --------- | ----------- | -
|                                                                                      |                                                                               | Year Ended December 31,               |                                                    
|                                                                                      |                                                                               |                                       |                                                    
|                                                                                      |                                                                               | 2004                                  |                                                     |                                                     | 2003       |             |             | 2002       |           
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Operating activities                                                                  |                                                                               |                                       |                                                     |                                                     |            |             |             |            |            |             |             |           
|Net income                                                                            |                                                                               | $                                     | 26,293,000                                          |                                                     |            | $           | 19,737,000  |            |            | $           | 1,779,000   |           
|Adjustments to reconcile net income to net cash provided by
    operating activities: |                                                                               |                                       |                                                     |                                                     |            |             |             |            |            |             |             |           
|                                                                                      | Depreciation                                                                  |                                       |                                                     | 16,252,000                                          |            |             |             | 13,114,000 |            |             |             | 14,019,000 |           
|                                                                                      | Amortization and write-off of intangibles and stock based
    compensation    |                                       |                                                     | 7,253,000                                           |            |             |             | 6,015,000  |            |             |             | 5,674,000  |           
|                                                                                      | Accretion of discount on marketable securities                                |                                       |                                                     | (33,000                                             | )          |             |             | 276,000    |            |             |             | 204,000    |           
|                                                                                      | Deferred compensation expense                                                 |                                       |                                                     | 2,019,000                                           |            |             |             | 124,000    |            |             |             |           |           
|                                                                                      | Minority interest                                                             |                                       |                                                     | 637,000                                             |            |             |             | 157,000    |            |             |             | 187,000    |           
|                                                                                      | Charge for in-process research and development                                |                                       |                                                     |                                                    |            |             |             |           |            |             |             | 18,537,000 |           
|                                                                                      | Income tax benefit from exercise of stock options                             |                                       |                                                     | 12,583,000                                          |            |             |             | 8,077,000  |            |             |             | 10,581,000 |           
|                                                                                      | Impairment of investment                                                      |                                       |                                                     | 498,000                                             |            |             |             | 2,230,000  |            |             |             |           |           
|                                                                                      | Loss on disposal of assets                                                    |                                       |                                                     | 94,000                                              |            |             |             |           |            |             |             |           |           
|                                                                                      | Gain on issuance of subsidiary stock                                          |                                       |                                                     | (292,000                                            | )          |             |             | (249,000   | )          |             |             | (2,560,000 | )         
|                                                                                      | Changes in assets and liabilities, excluding the effects of
    acquisitions: |                                       |                                                     |                                                     |            |             |             |            |            |             |             |            |           
|                                                                                      |                                                                               | Accounts receivable                   |                                                     |                                                     | (8,003,000 | )           |             |            | (9,888,000 | )           |             |            | (5,164,000 | )        
|                                                                                      |                                                                               | Inventory                             |                                                     |                                                     | (1,756,000 | )           |             |            | 305,000    |             |             |            | 713,000    |          
|                                                                                      |                                                                               | Prepaid expenses and other assets     |                                                     |                                                     | (5,749,000 | )           |             |            | (3,863,000 | )           |             |            | (2,008,000 | )        
|                                                                                      |                                                                               | Accounts payable and accrued expenses |                                                     |                                                     | 115,000    |             |             |            | 7,100,000  |             |             |            | (2,031,000 | )        
|                                                                                      |                                                                               | Deferred revenues                     |                                                     |                                                     | 15,064,000 |             |             |            | 5,542,000  |             |             |            | 8,975,000  |          
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|                                                                                      |                                                                               |                                       |                                                     | Net cash provided by operating activities           |            |             | 64,975,000  |            |            |             | 48,677,000  |            |            |           | 48,906,000  |  
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Investing activities                                                                  |                                                                               |                                       |                                                     |                                                     |            |             |             |            |            |             |             |           
|Acquisitions, net of cash received                                                    |                                                                               |                                       | (33,247,000                                         | )                                                   |            |             |            |            |            |             | (3,461,000  | )         
|Purchases of marketable securities                                                    |                                                                               |                                       | (87,685,000                                         | )                                                   |            |             | (76,493,000 | )          |            |             | (81,115,000 | )         
|Net proceeds from maturity of marketable securities                                   |                                                                               |                                       | 62,767,000                                          |                                                     |            |             | 84,267,000  |            |            |             | 82,041,000  |           
|(Additions to) release of restricted cash and marketable
    securities               |                                                                               |                                       | 2,460,000                                           |                                                     |            |             | 1,930,000   |            |            |             | (2,190,000  | )         
|Purchases of property and equipment                                                   |                                                                               |                                       | (14,502,000                                         | )                                                   |            |             | (7,212,000  | )          |            |             | (10,911,000 | )         
|Net proceeds from issuance of subsidiary stock                                        |                                                                               |                                       | 453,000                                             |                                                     |            |             | 376,000     |            |            |             |            |           
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|                                                                                      |                                                                               |                                       |                                                     | Net cash (used) in investing provided by activities |            |             | (69,754,000 | )          |            |             | 2,868,000   |            |            |           | (15,636,000 | )
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Financing activities                                                                  |                                                                               |                                       |                                                     |                                                     |            |             |             |            |            |             |             |           
|Proceeds from exercise of stock options                                               |                                                                               |                                       | 5,896,000                                           |                                                     |            |             | 1,008,000   |            |            |             | 3,697,000   |           
|Proceeds from employee stock purchase plan                                            |                                                                               |                                       | 1,417,000                                           |                                                     |            |             | 1,609,000   |            |            |             | 2,095,000   |           
|Repurchase of unvested stock                                                          |                                                                               |                                       |                                                    |                                                     |            |             |            |            |            |             | (10,000     | )         
|Purchases of treasury stock                                                           |                                                                               |                                       | (56,013,000                                         | )                                                   |            |             | (16,346,000 | )          |            |             | (2,034,000  | )         
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|                                                                                      |                                                                               |                                       | Net cash provided by (used in) financing activities |                                                     |            | (48,700,000 | )           |            |            | (13,729,000 | )           |            |            | 3,748,000 |            
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Foreign currency impact on cash                                                       |                                                                               |                                       | 1,396,000                                           |                                                     |            |             | 6,098,000   |            |            |             | 3,261,000   |           
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Net increase (decrease) in cash and cash equivalents                                  |                                                                               |                                       | (52,083,000                                         | )                                                   |            |             | 43,914,000  |            |            |             | 40,279,000  |           
|Cash and cash equivalents at beginning of year                                        |                                                                               |                                       | 192,231,000                                         |                                                     |            |             | 148,317,000 |            |            |             | 108,038,000 |           
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Cash and cash equivalents at end of year                                              |                                                                               | $                                     | 140,148,000                                         |                                                     |            | $           | 192,231,000 |            |            | $           | 148,317,000 |           
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           
|Supplemental cash flow disclosure                                                     |                                                                               |                                       |                                                     |                                                     |            |             |             |            |            |             |             |           
|Income taxes paid                                                                     |                                                                               | $                                     | 4,126,000                                           |                                                     |            | $           | 2,041,000   |            |            | $           | 4,040,000   |           
|                                                                                      |                                                                               |                                       |                                                     |                                                     |            |             |             |            |           



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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


December 31, 2004






|   |                                
|-- | -------------------------------
|1. | SIGNIFICANT ACCOUNTING POLICIES

Description of Business




Principles of Consolidation






Foreign Currency Translations




Use of Estimates






| |                    
| | -------------------
| | Revenue recognition





| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Product licenses and sales, which include revenue from
    sales of perpetual software licenses and products;                                               
|
| |  | Subscription revenues, which include product support and
    content updates, term licenses, subscription licenses and
    managed service arrangements; and
|
| |  | Professional services revenues, which includes fee-based
    service engagements and training.                                                              

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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)


Software Revenue
Recognition, Software
Revenue Recognition with Respect to Certain Transactions,




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



| |                           
| | --------------------------
| | Product licenses and sales









| |                      
| | ---------------------
| | Subscription revenues







| |                               
| | ------------------------------
| | Professional services revenues



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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)






| |                               
| | ------------------------------
| | Multiple elements arrangements





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



Cost of Revenues




Cash and Cash Equivalents




Marketable Securities




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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)


Concentrations of Credit and Supplier Risk










Fair Value of Financial Instruments




Property and Equipment




Inventory




Goodwill and Intangibles


Goodwill and Other Intangible Assets


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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)






|                             |                        |              |             |            |              |   |             |             |             |   |              |            |            |   |             |            |             |  
|---------------------------- | ---------------------- | ------------ | ----------- | ---------- | ------------ | - | ----------- | ----------- | ----------- | - | ------------ | ---------- | ---------- | - | ----------- | ---------- | ----------- | -
|                             |                        | December 31, |            
|                             |                        |              |            
|                             |                        | 2004         |             |            | 2003         |  
|                             |                        |              |             |            |              |  
|                             |                        | Gross        |             |            |              |   | Gross       |             |             |  
|                             |                        | Carrying     |             |            | Accumulated  |   |             | Carrying    |             |   | Accumulated  |           
|                             |                        | Amount       |             |            | Amortization |   |             | Amount      |             |   | Amortization |           
|                             |                        |              |             |            |              |   |             |             |             |   |              |           
|Goodwill                     |                        | $            | 251,446,000 |            |              | $ | (27,381,000 | )           |             | $ | 228,684,000  |            |            | $ | (27,381,000 | )         
|                             |                        |              |             |            |              |   |             |             |             |   |              |           
|Amortized intangible assets: |                        |              |             |            |              |   |             |             |             |   |              |            |            |   |             |           
|                             | Core technology        |              | $           | 3,853,000  |              |   | $           | (3,002,000  | )           |   | $            | 3,853,000  |            |   | $           | (2,521,000 | )          
|                             | Developed technology   |              |             | 34,775,000 |              |   |             | (16,235,000 | )           |   |              | 17,808,000 |            |   |             | (9,576,000 | )          
|                             | Customer relationships |              |             | 2,086,000  |              |   |             | (1,714,000  | )           |   |              | 1,566,000  |            |   |             | (1,402,000 | )          
|                             |                        |              |             |            |              |   |             |             |             |   |              |           
|                             |                        | Total        |             | $          | 40,714,000   |   |             | $           | (20,951,000 | ) |              | $          | 23,227,000 |   |             | $          | (13,499,000 | )
|                             |                        |              |             |            |              |   |             |             |             |   |              |           





|                       |  |              |           |  |      |   |           |      |  |   |           | 
|---------------------- |  | ------------ | --------- |  | ---- | - | --------- | ---- |  | - | --------- | 
|                       |  | Year Ended   |          
|                       |  | December 31, |          
|                       |  |              |          
|                       |  | 2004         |           |  | 2003 |   |           | 2002 | 
|                       |  |              |           |  |      |   |           |      | 
|Core technology        |  | $            | 481,000   |  |      | $ | 481,000   |      |  | $ | 481,000   | 
|Developed technology   |  |              | 6,370,000 |  |      |   | 3,923,000 |      |  |   | 3,168,000 | 
|Work force             |  |              |          |  |      |   | 426,000   |      |  |   | 100,000   | 
|Customer relationships |  |              | 324,000   |  |      |   | 88,000    |      |  |   | 830,000   | 







|             |      |        |   |       |        | 
|------------ | ---- | ------ | - | ----- | ------ | 
|             |      | Amount |  
|             |      |        |  
|Fiscal year: |      |        |   |      
|             | 2005 |        | $ | 7,287 |       
|             | 2006 |        |   | 5,188 |       
|             | 2007 |        |   | 3,252 |       
|             | 2008 |        |   | 3,226 |       
|             | 2009 |        |   | 810   |       
|             |      |        |  
|             |      | Total  |   | $     | 19,763 | 
|             |      |        |  

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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)




Research and Development Costs


Accounting for the Costs of
Computer Software to Be Sold, Leased, or Otherwise Marketed,


Advertising Costs




Stock-Based Compensation


Accounting for Stock-Based Compensation Accounting for Stock-Based
Compensation  Transition and Disclosure, Accounting for Stock Issued to Employees




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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)




|                                                                                                     |  |                          |             |   |      |   |             |      |  |   |             |  
|---------------------------------------------------------------------------------------------------- |  | ------------------------ | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | -
|                                                                                                     |  | Years Ended December 31, |            
|                                                                                                     |  |                          |            
|                                                                                                     |  | 2004                     |             |   | 2003 |   |             | 2002 | 
|                                                                                                     |  |                          |             |   |      |   |             |      | 
|Net income as reported                                                                               |  | $                        | 26,293,000  |   |      | $ | 19,737,000  |      |  | $ | 1,779,000   |  
|Add: stock-based compensation included in reported net income,
    net of income taxes               |  |                          | 1,319,000   |   |      |   |            |      |  |   |            |  
|Less: Stock-based compensation expense computed under the fair
    value method, net of income taxes |  |                          | (26,933,000 | ) |      |   | (28,099,000 | )    |  |   | (28,589,000 | )
|                                                                                                     |  |                          |             |   |      |   |             |      | 
|Pro forma net income (loss)                                                                          |  | $                        | 679,000     |   |      | $ | (8,362,000  | )    |  | $ | (26,810,000 | )
|                                                                                                     |  |                          |             |   |      |   |             |      | 
|Basic net income per share of Common Stock, as reported                                              |  | $                        | 0.56        |   |      | $ | 0.40        |      |  | $ | 0.04        |  
|                                                                                                     |  |                          |             |   |      |   |             |      | 
|Diluted net income per share of Common Stock, as reported                                            |  | $                        | 0.54        |   |      | $ | 0.39        |      |  | $ | 0.04        |  
|                                                                                                     |  |                          |             |   |      |   |             |      | 
|Pro forma basic and diluted net income (loss) per share of
    Common Stock and equivalents          |  | $                        | 0.01        |   |      | $ | (0.17       | )    |  | $ | (0.55       | )
|                                                                                                     |  |                          |             |   |      |   |             |      | 





|                                                                  |  |                          |       |   |      |   |      |      |  |   |       |  
|----------------------------------------------------------------- |  | ------------------------ | ----- | - | ---- | - | ---- | ---- |  | - | ----- | -
|                                                                  |  | Years Ended December 31, |      
|                                                                  |  |                          |      
|                                                                  |  | 2004                     |       |   | 2003 |   |      | 2002 | 
|                                                                  |  |                          |       |   |      |   |      |      | 
|Volatility                                                        |  |                          | 49    | % |      |   | 75   | %    |  |   | 122   | %
|Weighted-average expected lives (in years)                        |  |                          | 5     |   |      |   | 5    |      |  |   | 5     |  
|Expected dividend yields                                          |  |                          |      |   |      |   |     |      |  |   |      |  
|Weighted-average risk-free interest rates                         |  |                          | 3.66  | % |      |   | 2.54 | %    |  |   | 4.20  | %
|Weighted-average fair value per share of options granted          |  | $                        | 7.87  |   |      | $ | 6.90 |      |  | $ | 21.56 |  
|Weighted-average fair value per share of restricted stock awarded |  | $                        | 17.45 |   |      |   |     |      |  |   |      |  



Accounting for Issuances of Stock by a Subsidiary




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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




1. SIGNIFICANT ACCOUNTING POLICIES 
(Continued)




Accumulated Other Comprehensive Income




Income Per Share




Recently Issued Accounting Standards


Share-Based Payment, Accounting for
Stock-Based Compensation. Accounting for Stock Issued to
Employees.






|   |                                             
|-- | --------------------------------------------
|2. | BUSINESS COMBINATIONS AND ASSET ACQUISITIONS





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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                                                               
|-- | --------------------------------------------------------------
|2. | BUSINESS COMBINATIONS AND ASSET ACQUISITIONS 
    (Continued)



|                                   |  |   |        |  
|---------------------------------- |  | - | ------ | -
|Net tangible liabilities of Cobion |  | $ | (2,736 | )
|Developed technology               |  |   | 16,030 |  
|Customer relationships             |  |   | 516    |  
|Deferred income taxes              |  |   | (2,655 | )
|Goodwill                           |  |   | 22,359 |  
|                                   |  |   |       
|                                   |  | $ | 33,514 |  
|                                   |  |   |       









Determining Whether a
Nonmonetary Transaction Involves Receipt of Productive Assets or
of a Business.


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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                                                               
|-- | --------------------------------------------------------------
|2. | BUSINESS COMBINATIONS AND ASSET ACQUISITIONS 
    (Continued)



|                                    |  |   |            |  
|----------------------------------- |  | - | ---------- | -
|Net liabilities of vCIS             |  | $ | (100,000   | )
|In-process research and development |  |   | 18,500,000 |  
|Assembled workforce                 |  |   | 1,200,000  |  
|                                    |  |   |           
|                                    |  | $ | 19,600,000 |  
|                                    |  |   |           







|   |                      
|-- | ---------------------
|3. | MARKETABLE SECURITIES



|                                           |                                                   |                                                                 |   |            |            |  |   |            |            | 
|------------------------------------------ | ------------------------------------------------- | --------------------------------------------------------------- | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                           |                                                   | 2004                                                            |   |            | 2003       | 
|                                           |                                                   |                                                                 |   |            |            | 
|Unrestricted marketable securities:        |                                                   |                                                                 |   |            |            |  |   |           
|                                           | Corporate securities                              |                                                                 | $ | 28,146,000 |            |  | $ | 9,585,000  |           
|                                           | Taxable auction rate securities                   |                                                                 |   | 27,300,000 |            |  |   | 10,500,000 |           
|                                           | US government and government-sponsored securities |                                                                 |   | 15,455,000 |            |  |   | 25,865,000 |           
|                                           |                                                   |                                                                 |   |            |            | 
|                                           |                                                   | Total unrestricted marketable: securities                       |   | $          | 70,901,000 |  |   | $          | 45,950,000 | 
|                                           |                                                   |                                                                 |   |            |            | 
|Restricted cash and marketable securities: |                                                   |                                                                 |   |            |            |  |   |           
|                                           | Corporate securities                              |                                                                 | $ | 4,772,000  |            |  | $ | 5,885,000  |           
|                                           | Taxable auction rate securities                   |                                                                 |   | 2,450,000  |            |  |   | 700,000    |           
|                                           | US government and government-sponsored securities |                                                                 |   | 3,078,000  |            |  |   | 5,294,000  |           
|                                           | Cash equivalents                                  |                                                                 |   |           |            |  |   | 881,000    |           
|                                           |                                                   |                                                                 |   |            |            | 
|                                           |                                                   | Total restricted marketable securities and
    cash equivalents |   | $          | 10,300,000 |  |   | $          | 12,760,000 | 
|                                           |                                                   |                                                                 |   |            |            | 

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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                                    
|-- | -----------------------------------
|3. | MARKETABLE SECURITIES  (Continued)





|   |                   
|-- | ------------------
|4. | STOCK OPTION PLANS







|                                 |           |           |           |           |          |   |       |           |          |  |           |            |   |           |       |       |          |  |           |            |   |   |       |       | 
|-------------------------------- | --------- | --------- | --------- | --------- | -------- | - | ----- | --------- | -------- |  | --------- | ---------- | - | --------- | ----- | ----- | -------- |  | --------- | ---------- | - | - | ----- | ----- | 
|                                 |           | 2004      |           |           | 2003     |   |       | 2002      |         
|                                 |           |           |           |           |          |   |       |           |         
|                                 |           |           |           | Weighted  |          |   |       |           | Weighted |  |           |            |   | Weighted  |      
|                                 |           |           |           | Average   |          |   |       |           | Average  |  |           |            |   | Average   |      
|                                 |           | Number of |           |           | Exercise |   |       | Number of |          |  | Exercise  |            |   | Number of |       |       | Exercise | 
|                                 |           | Shares    |           |           | Price    |   |       | Shares    |          |  | Price     |            |   | Shares    |       |       | Price    | 
|                                 |           |           |           |           |          |   |       |           |          |  |           |            |   |           |       |       |          | 
|Outstanding at beginning of year |           |           | 7,637,000 |           |          | $ | 22.26 |           |          |  | 6,756,000 |            |   | $         | 31.64 |       |          |  | 5,004,000 |            |   | $ | 36.98 |      
|                                 | Granted   |           |           | 2,668,000 |          |   |       | 16.69     |          |  |           | 2,898,000  |   |           |       | 11.14 |          |  |           | 3,773,000  |   |   |       | 25.33 | 
|                                 | Exercised |           |           | (493,000  | )        |   |       | 20.26     |          |  |           | (136,000   | ) |           |       | 7.50  |          |  |           | (587,000   | ) |   |       | 6.30  | 
|                                 | Canceled  |           |           | (967,000  | )        |   |       | 25.38     |          |  |           | (1,881,000 | ) |           |       | 39.95 |          |  |           | (1,469,000 | ) |   |       | 42.82 | 
|                                 | Assumed   |           |           |          |          |   |       |          |          |  |           |           |   |           |       |      |          |  |           | 35,000     |   |   |       | 0.94  | 
|                                 |           |           |           |           |          |   |       |           |          |  |           |            |   |           |       |       |          | 
|Outstanding at end of year       |           |           | 8,845,000 |           |          |   | 20.82 |           |          |  | 7,637,000 |            |   |           | 22.26 |       |          |  | 6,756,000 |            |   |   | 31.64 |      
|                                 |           |           |           |           |          |   |       |           |          |  |           |            |   |           |       |       |          | 
|Exercisable at end of year       |           |           | 5,242,000 |           |          |   | 23.55 |           |          |  | 2,840,000 |            |   |           | 28.19 |       |          |  | 2,032,000 |            |   |   | 32.06 |      
|                                 |           |           |           |           |          |   |       |           |          |  |           |            |   |           |       |       |          | 



50



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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                                 
|-- | --------------------------------
|4. | STOCK OPTION PLANS  (Continued)



|                         |  |                     |           |               |                        |  |      |          |  |        |              |  |  |          |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------- | ---------------------- |  | ---- | -------- |  | ------ | ------------ |  |  | -------- | --------- |  |  | - | ----- | 
|                         |  |                     |           | Options Fully |                       
|                         |  | Options Outstanding |           |               | Vested and Exercisable | 
|                         |  |                     |           |               |                        | 
|                         |  | Number of           |           |               | Weighted               |  |      |          |  | Number |              |  | 
|                         |  | Options             |           |               | Average                |  |      | Weighted |  |        | Exercisable  |  |  | Weighted |          
|                         |  | Outstanding at      |           |               | Remaining              |  |      | Average  |  |        | at           |  |  | Average  |          
|                         |  | December 31,        |           |               | Contractual            |  |      | Exercise |  |        | December 31, |  |  | Exercise |          
|Range of Exercise Prices |  | 2004                |           |               | Life                   |  |      | Price    |  |        | 2004         |  |  | Price    |          
|                         |  |                     |           |               |                        |  |      |          |  |        |              |  |  |          |          
|$.08-9.11                |  |                     | 407,000   |               |                        |  | 4.57 |          |  | $      | 5.74         |  |  |          | 363,000   |  |  | $ | 5.34  | 
|$10.00-19.19             |  |                     | 5,306,000 |               |                        |  | 7.43 |          |  |        | 14.04        |  |  |          | 2,436,000 |  |  |   | 14.30 | 
|$19.98-29.44             |  |                     | 1,226,000 |               |                        |  | 6.72 |          |  |        | 21.56        |  |  |          | 816,000   |  |  |   | 21.88 | 
|$30.63-39.75             |  |                     | 1,238,000 |               |                        |  | 6.86 |          |  |        | 32.97        |  |  |          | 1,075,000 |  |  |   | 32.96 | 
|$49.81-85.63             |  |                     | 668,000   |               |                        |  | 5.69 |          |  |        | 59.97        |  |  |          | 552,000   |  |  |   | 60.47 | 
|                         |  |                     |           |               |                        |  |      |          |  |        |              |  |  |          |          
|                         |  |                     | 8,845,000 |               |                        |  | 6.99 |          |  | $      | 20.82        |  |  |          | 5,242,000 |  |  | $ | 23.55 | 
|                         |  |                     |           |               |                        |  |      |          |  |        |              |  |  |          |          



5. ADOPTION OF SHAREHOLDER RIGHTS PLAN








6. OTHER INCOME (EXPENSE)




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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




6. OTHER INCOME
(EXPENSE)  (Continued)










7. COMMITMENTS AND CONTINGENCIES




|           |                              |                  |            |            | 
|---------- | ---------------------------- | ---------------- | ---------- | ---------- | 
|           |                              | Non-Cancelable   |           
|           |                              | Operating Leases |           
|           |                              |                  |           
|2005       |                              | $                | 13,366,000 |           
|2006       |                              |                  | 12,299,000 |           
|2007       |                              |                  | 9,893,000  |           
|2008       |                              |                  | 8,716,000  |           
|2009       |                              |                  | 8,199,000  |           
|Thereafter |                              |                  | 26,904,000 |           
|           |                              |                  |           
|           | Total minimum lease payments |                  | $          | 79,377,000 | 
|           |                              |                  |           





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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




7. COMMITMENTS AND
CONTINGENCIES  (Continued)










|   |             
|-- | ------------
|8. | INCOME TAXES



|          |                               |                                  |           |            |            |  |            |            |            |  |            |            |            | 
|--------- | ----------------------------- | -------------------------------- | --------- | ---------- | ---------- |  | ---------- | ---------- | ---------- |  | ---------- | ---------- | ---------- | 
|          |                               | Year Ended December 31,          |          
|          |                               |                                  |          
|          |                               | 2004                             |           |            | 2003       |  |            | 2002       |           
|          |                               |                                  |           |            |            |  |            |            |           
|Current:  |                               |                                  |           |            |            |  |            |            |            |  |            |           
|          | Federal                       |                                  | $         | 1,563,000  |            |  | $          | 8,069,000  |            |  | $          | 10,404,000 |           
|          | State, net of federal benefit |                                  |           | 636,000    |            |  |            | 1,377,000  |            |  |            | 637,000    |           
|          | Foreign                       |                                  |           | 3,340,000  |            |  |            | 3,346,000  |            |  |            | 2,035,000  |           
|          |                               |                                  |           |            |            |  |            |            |           
|          |                               |                                  | 5,539,000 |            |            |  | 12,792,000 |            |            |  | 13,076,000 |           
|Deferred: |                               |                                  |           |            |            |  |            |            |            |  |            |           
|          | Federal                       |                                  |           | 11,270,000 |            |  |            |           |            |  |            |           |           
|          | State, net of federal benefit |                                  |           | 547,000    |            |  |            |           |            |  |            |           |           
|          | Foreign                       |                                  |           | (1,963,000 | )          |  |            | (1,561,000 | )          |  |            |           |           
|          |                               |                                  |           |            |            |  |            |            |           
|          |                               |                                  | 9,854,000 |            |            |  | (1,561,000 | )          |            |  |           |           
|          |                               |                                  |           |            |            |  |            |            |           
|          |                               | Total provision for income taxes |           | $          | 15,393,000 |  |            | $          | 11,231,000 |  |            | $          | 13,076,000 | 
|          |                               |                                  |           |            |            |  |            |            |           

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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                           
|-- | --------------------------
|8. | INCOME TAXES  (Continued)



|                        |  |                         |            |  |      |   |            |      |  |   |            |  
|----------------------- |  | ----------------------- | ---------- |  | ---- | - | ---------- | ---- |  | - | ---------- | -
|                        |  | Year Ended December 31, |           
|                        |  |                         |           
|                        |  | 2004                    |            |  | 2003 |   |            | 2002 | 
|                        |  |                         |            |  |      |   |            |      | 
|U.S. operations         |  | $                       | 33,458,000 |  |      | $ | 27,838,000 |      |  | $ | 15,376,000 |  
|Asia Pacific operations |  |                         | 5,509,000  |  |      |   | 694,000    |      |  |   | 2,455,000  |  
|EMEA operations         |  |                         | 2,074,000  |  |      |   | 1,424,000  |      |  |   | (2,136,000 | )
|Other                   |  |                         | 645,000    |  |      |   | 1,012,000  |      |  |   | (840,000   | )
|                        |  |                         |            |  |      |   |            |      | 
|                        |  | $                       | 41,686,000 |  |      | $ | 30,968,000 |      |  | $ | 14,855,000 |  
|                        |  |                         |            |  |      |   |            |      | 



|                                                            |  |                         |            |   |      |   |            |      |  |   |            |  
|----------------------------------------------------------- |  | ----------------------- | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                            |  | Year Ended December 31, |           
|                                                            |  |                         |           
|                                                            |  | 2004                    |            |   | 2003 |   |            | 2002 | 
|                                                            |  |                         |            |   |      |   |            |      | 
|Federal income taxes at 35% applied to pretax income (loss) |  | $                       | 14,590,000 |   |      | $ | 10,839,000 |      |  | $ | 5,200,000  |  
|State income taxes, net of federal income tax benefit       |  |                         | 1,182,000  |   |      |   | 1,377,000  |      |  |   | 637,000    |  
|Research and development tax credits                        |  |                         | 233,000    |   |      |   | (1,300,000 | )    |  |   | (1,496,000 | )
|Foreign operations differential in rate                     |  |                         | (760,000   | ) |      |   | (19,000    | )    |  |   | 1,441,000  |  
|Deferred compensation                                       |  |                         | 30,000     |   |      |   | 127,000    |      |  |   | 383,000    |  
|Write-off of in-process research and development            |  |                         |           |   |      |   |           |      |  |   | 6,488,000  |  
|Change in valuation allowance                               |  |                         | (400,000   | ) |      |   |           |      |  |   |           |  
|Other                                                       |  |                         | 518,000    |   |      |   | 207,000    |      |  |   | 423,000    |  
|                                                            |  |                         |            |   |      |   |            |      | 
|                                                            |  | $                       | 15,393,000 |   |      | $ | 11,231,000 |      |  | $ | 13,076,000 |  
|                                                            |  |                         |            |   |      |   |            |      | 

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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                           
|-- | --------------------------
|8. | INCOME TAXES  (Continued)



|                                 |                                                   |                                       |   |            |            |  |   |             |            | 
|-------------------------------- | ------------------------------------------------- | ------------------------------------- | - | ---------- | ---------- |  | - | ----------- | ---------- | 
|                                 |                                                   | December 31,                          |  
|                                 |                                                   |                                       |  
|                                 |                                                   | 2004                                  |   |            | 2003       | 
|                                 |                                                   |                                       |   |            |            | 
|Deferred income tax liabilities: |                                                   |                                       |   |            |            |  |   |            
|                                 | Amortization                                      |                                       | $ | 6,383,000  |            |  | $ | 2,766,000   |           
|                                 | Gain on issuance of subsidiary stock              |                                       |   | 6,612,000  |            |  |   | 6,502,000   |           
|                                 |                                                   |                                       |   |            |            | 
|                                 |                                                   | Total deferred income tax liabilities |   |            | 12,995,000 |  |   |             | 9,268,000  | 
|Deferred income tax assets:      |                                                   |                                       |   |            |            |  |   |            
|                                 | Depreciation                                      |                                       |   | 930,000    |            |  |   | 232,000     |           
|                                 | Accrued liabilities                               |                                       |   | 1,115,000  |            |  |   | 710,000     |           
|                                 | Allowance for doubtful accounts                   |                                       |   | 868,000    |            |  |   | 1,237,000   |           
|                                 | Deferred revenue                                  |                                       |   | 2,263,000  |            |  |   | 506,000     |           
|                                 | Loss from impairment of investment                |                                       |   | 1,145,000  |            |  |   | 936,000     |           
|                                 | Net operating loss carryforwards                  |                                       |   | 7,231,000  |            |  |   | 8,290,000   |           
|                                 | Foreign tax credit carryforwards                  |                                       |   |           |            |  |   | 2,814,000   |           
|                                 | Research and development tax credit carryforwards |                                       |   | 3,918,000  |            |  |   | 7,662,000   |           
|                                 |                                                   |                                       |   |            |            | 
|                                 |                                                   | Total deferred income tax assets      |   |            | 17,470,000 |  |   |             | 22,387,000 | 
|                                 |                                                   |                                       |   |            |            | 
|                                 |                                                   | Net deferred tax income tax asset     |   |            | 4,475,000  |  |   |             | 13,119,000 | 
|                                 | Less valuation allowance                          |                                       |   | (3,301,000 | )          |  |   | (11,558,000 | )         
|                                 |                                                   |                                       |   |            |            | 
|                                 |                                                   | Net deferred income tax assets        |   | $          | 1,174,000  |  |   | $           | 1,561,000  | 
|                                 |                                                   |                                       |   |            |            | 









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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                           
|-- | --------------------------
|8. | INCOME TAXES  (Continued)



9. EMPLOYEE STOCK AND BENEFIT PLANS






10. INCOME PER SHARE




|                             |                                                                                            |                         |      |            |      |   |      |            |  |   |      |            | 
|---------------------------- | ------------------------------------------------------------------------------------------ | ----------------------- | ---- | ---------- | ---- | - | ---- | ---------- |  | - | ---- | ---------- | 
|                             |                                                                                            | Year Ended December 31, |     
|                             |                                                                                            |                         |     
|                             |                                                                                            | 2004                    |      |            | 2003 |   |      | 2002       | 
|                             |                                                                                            |                         |      |            |      |   |      |            | 
|Numerator:                   |                                                                                            |                         |      |            |      |   |      |            |  |   |      |           
|                             | Net income                                                                                 |                         | $    | 26,293,000 |      |   | $    | 19,737,000 |  |   | $    | 1,779,000  | 
|Denominator:                 |                                                                                            |                         |      |            |      |   |      |            |  |   |      |           
|                             | Denominator for basic net income per share  weighted
    average shares                   |                         |      | 46,985,000 |      |   |      | 49,155,000 |  |   |      | 48,456,000 | 
|                             | Effect of dilutive stock options                                                           |                         |      | 1,473,000  |      |   |      | 863,000    |  |   |      | 702,000    | 
|                             |                                                                                            |                         |      |            |      |   |      |            | 
|                             | Denominator for diluted net income per share 
    weighted average shares and equivalents |                         |      | 48,458,000 |      |   |      | 50,018,000 |  |   |      | 49,158,000 | 
|                             |                                                                                            |                         |      |            |      |   |      |            | 
|Basic net income per share   |                                                                                            | $                       | 0.56 |            |      | $ | 0.40 |            |  | $ | 0.04 |           
|                             |                                                                                            |                         |      |            |      |   |      |            | 
|Diluted net income per share |                                                                                            | $                       | 0.54 |            |      | $ | 0.39 |            |  | $ | 0.04 |           
|                             |                                                                                            |                         |      |            |      |   |      |            | 



11. SEGMENTS AND GEOGRAPHIC INFORMATION




56



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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




11. SEGMENTS AND GEOGRAPHIC
INFORMATION  (Continued)






57



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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




11. SEGMENTS AND GEOGRAPHIC
INFORMATION  (Continued)


Disclosures
about Segments of an Enterprise and Related
Information


|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |             |           |           |   |             |             |             | 
|--------------------------------------------- | --------------------------------------- | ---------------------- | ----------- | ---------- | ----------- | - | ---------- | ------------ | ---------- | - | ----------- | ---------- | ---------- | ----- | ----------- | --------- | --------- | - | ----------- | ----------- | ----------- | 
|                                              |                                         | Americas               |             |            | EMEA        |   |            | Asia/Pacific |            |   | Unallocated |            |            | Total |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|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  |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|As of or for the year ended December 31, 2002 |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |             |           |           |   |             |            
|Revenues from external customers:             |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |             |           |           |   |             |            
|                                              | Product licenses and sales              |                        | $           | 82,456,000 |             |   | $          | 19,459,000   |            |   | $           | 19,178,000 |            |       | $           |          |           |   | $           | 121,093,000 |            
|                                              | Subscriptions                           |                        |             | 71,224,000 |             |   |            | 12,952,000   |            |   |             | 8,769,000  |            |       |             |          |           |   |             | 92,945,000  |            
|                                              | Professional services                   |                        |             | 20,301,000 |             |   |            | 5,228,000    |            |   |             | 3,718,000  |            |       |             |          |           |   |             | 29,247,000  |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|                                              |                                         | Total revenue          |             |            | 173,981,000 |   |            |              | 37,639,000 |   |             |            | 31,665,000 |       |             |           |          |   |             |             | 243,285,000 | 
|Cost of revenues:                             |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |             |           |           |   |             |            
|                                              | Product licenses and sales              |                        |             | 6,633,000  |             |   |            |             |            |   |             | 55,000     |            |       |             |          |           |   |             | 6,688,000   |            
|                                              | Amortization of acquired technology     |                        |             |           |             |   |            |             |            |   |             |           |            |       |             | 3,649,000 |           |   |             | 3,649,000   |            
|                                              | Subscriptions and professional services |                        |             | 34,652,000 |             |   |            | 8,249,000    |            |   |             | 8,232,000  |            |       |             |          |           |   |             | 51,133,000  |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|                                              |                                         | Total cost of revenues |             |            | 41,285,000  |   |            |              | 8,249,000  |   |             |            | 8,287,000  |       |             |           | 3,649,000 |   |             |             | 61,470,000  | 
|Operating expenses                            |                                         |                        | 63,477,000  |            |             |   | 20,624,000 |              |            |   | 9,578,000   |            |            |       | 80,113,000  |           |           |   | 173,792,000 |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|Total expenses                                |                                         |                        | 104,762,000 |            |             |   | 28,873,000 |              |            |   | 17,865,000  |            |            |       | 83,762,000  |           |           |   | 235,262,000 |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|Segment operating income (loss)               |                                         | $                      | 69,219,000  |            |             | $ | 8,766,000  |              |            | $ | 13,800,000  |            |            | $     | (83,762,000 | )         |           | $ | 8,023,000   |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|Accounts receivable, net                      |                                         | $                      | 33,945,000  |            |             | $ | 13,459,000 |              |            | $ | 9,296,000   |            |            | $     |            |           |           | $ | 56,700,000  |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            
|Property and equipment, net                   |                                         | $                      | 33,058,000  |            |             | $ | 2,458,000  |              |            | $ | 6,203,000   |            |            | $     |            |           |           | $ | 41,719,000  |            
|                                              |                                         |                        |             |            |             |   |            |              |            |   |             |            |            |       |            

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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|    |                                   
|--- | ----------------------------------
|12. | ISSUANCES OF STOCK BY A SUBSIDIARY









|    |                            
|--- | ---------------------------
|13. | EXIT OR DISPOSAL ACTIVITIES







|    |                                        
|--- | ---------------------------------------
|14. | QUARTERLY FINANCIAL RESULTS (UNAUDITED)



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

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INTERNET SECURITY SYSTEMS, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|    |                                                          
|--- | ---------------------------------------------------------
|14. | QUARTERLY FINANCIAL RESULTS (UNAUDITED) 
    (Continued)

|                      |                  |       |   |            |        |  |   |            |  |  |        |            |  |  |   |            | 
|--------------------- | ---------------- | ----- | - | ---------- | ------ |  | - | ---------- |  |  | ------ | ---------- |  |  | - | ---------- | 
|                      |                  | First |   |            | Second |  |   | Third      |  |  | Fourth |           
|                      |                  |       |   |            |        |  |   |            |  |  |        |           
|2003 by quarter:      |                  |       |   |            |        |  |   |            |  |  |        |            |  |  |   |           
|                      | Revenues         |       | $ | 59,453,000 |        |  | $ | 59,125,000 |  |  | $      | 60,087,000 |  |  | $ | 67,116,000 | 
|                      | Operating income |       |   | 7,873,000  |        |  |   | 6,902,000  |  |  |        | 7,542,000  |  |  |   | 7,279,000  | 
|                      | Net income       |       |   | 5,362,000  |        |  |   | 4,891,000  |  |  |        | 5,035,000  |  |  |   | 4,449,000  | 
|Net income per share: |                  |       |   |            |        |  |   |            |  |  |        |            |  |  |   |           
|                      | Basic            |       | $ | 0.11       |        |  | $ | 0.10       |  |  | $      | 0.10       |  |  | $ | 0.09       | 
|                      | Diluted          |       | $ | 0.11       |        |  | $ | 0.10       |  |  | $      | 0.10       |  |  | $ | 0.09       | 



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SCHEDULE II


VALUATION AND QUALIFYING ACCOUNTS


|                                                      |  |              |            |  |           |   |           |            |            |   |             |   |  |   |            | 
|----------------------------------------------------- |  | ------------ | ---------- |  | --------- | - | --------- | ---------- | ---------- | - | ----------- | - |  | - | ---------- | 
|                                                      |  | Balance at   |            |  |           |   |           |            |           
|                                                      |  | Beginning of |            |  |           |   |           |            | Balance at |  
|                                                      |  | Year         |            |  | Provision |   |           | Write-offs |            |   | End of Year |  
|                                                      |  |              |            |  |           |   |           |            |            |   |             |  
|2002                                                  |  |              |            |  |           |   |           |            |            |   |             |   |  |   |            | 
|Allowance for Doubtful Accounts                       |  | $            | 2,563,000  |  |           | $ | 2,101,000 |            |            | $ | (1,874,000  | ) |  | $ | 2,790,000  | 
|                                                      |  |              |            |  |           |   |           |            |            |   |             |  
|Valuation allowance on net deferred income tax assets |  | $            | 27,112,000 |  |           | $ |          |            |            | $ | (8,431,000  | ) |  | $ | 18,681,000 | 
|                                                      |  |              |            |  |           |   |           |            |            |   |             |  
|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 | 
|                                                      |  |              |            |  |           |   |           |            |            |   |             |  
|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  | 
|                                                      |  |              |            |  |           |   |           |            |            |   |             |  

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SIGNATURES






| |                                
| | -------------------------------
| | INTERNET SECURITY SYSTEMS, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ RICHARD MACCHIA

| |                                                  
| | -------------------------------------------------
| |                                                  
| | Richard Macchia                                  
| | Senior Vice President and Chief Financial Officer



POWER OF ATTORNEY






|                                                     |  |                                                                             |  |                |  | 
|---------------------------------------------------- |  | --------------------------------------------------------------------------- |  | -------------- |  | 
|Name                                                 |  | Title                                                                       |  | Date          
|                                                     |  |                                                                             |  |               
|                                                    
|/s/ THOMAS E. NOONANThomas
    E. Noonan             |  | Chairman, President and Chief Executive (Principal Executive
    Officer)   |  | March 16, 2005
|                                                    
|/s/ CHRISTOPHER W.
    KLAUSChristopher
    W. Klaus |  | Secretary, Security Adviser and Director                                    |  | March 16, 2005
|                                                    
|/s/ RICHARD MACCHIARichard
    Macchia               |  | Senior Vice President and
    Chief Financial Officer                       |  | March 16, 2005
|                                                    
|/s/ MAUREEN RICHARDSMaureen
    Richards             |  | Vice President, Corporate Controller and (Principal Accounting
    Officer) |  | March 16, 2005
|                                                    
|/s/ RICHARD S. BODMANRichard
    S. Bodman           |  | Director                                                                    |  | March 16, 2005
|                                                    
|/s/ ROBERT E. DAVOLIRobert
    E. Davoli             |  | Director                                                                    |  | March 16, 2005
|                                                    
|/s/ STEVEN J. HEYERSteven
    J. Heyer               |  | Director                                                                    |  | March 16, 2005

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|                                               |  |          |  |                |  | 
|---------------------------------------------- |  | -------- |  | -------------- |  | 
|Name                                           |  | Title    |  | Date          
|                                               |  |          |  |               
|                                              
|/s/ SAM NUNNSam
    Nunn                       |  | Director |  | March 16, 2005
|                                              
|/s/ KEVIN J.
    OCONNORKevin
    J. OConnor |  | Director |  | March 16, 2005
|                                              
|/s/ DAVID N. STROHMDavid
    N. Strohm         |  | Director |  | March 16, 2005

63