<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549
                                        
                                   FORM 10-Q
                                        

(Mark one)

[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
    Act of 1934

                      FOR THREE MONTHS ENDED JUNE 30, 1998

                                       OR

[_] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
    Act of 1934


                        COMMISSION FILE NUMBER:  0-27696

                               GENSYM CORPORATION
             (Exact name of registrant as specified in its charter)

              DELAWARE                                  04-2932756
      (State or other jurisdiction of                (I.R.S. Employer
      incorporation or organization)                Identification No.)

                            125 CAMBRIDGEPARK DRIVE
                              Cambridge, MA 02140
                   (Address of principal executive offices)

                        TELEPHONE NUMBER (617) 547-2500
             (Registrant's telephone number, including area code)



     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:

         Yes  X                                    No    
             ---                                     --- 

     As of August 1, 1998 there were 6,464,770 shares of the Registrant's Common
Stock outstanding.

                                       1
<PAGE>
 
                               GENSYM CORPORATION
                                Form 10-Q INDEX

                         PART I. FINANCIAL INFORMATION

<TABLE> 
<CAPTION> 
                                                                       Page No.
                                                                       --------

<S>        <C>                                                         <C>
Item 1.    Condensed Consolidated Financial Statements:
 
           Condensed Consolidated Balance Sheets
           June 30, 1998 and December 31, 1997                            3
 
           Condensed Consolidated Statements of Operations
           Three and six months ended June 30, 1998 and 1997              4
 
           Condensed Consolidated Statements of Cash Flows
           Six months ended June 30, 1998 and 1997                        5
 
           Notes to Condensed Consolidated Financial Statements         6-7
 
Item 2.    Management's Discussion and Analysis of
           Financial Condition and Results of Operations               8-16
 
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    16
 
                          PART II. OTHER INFORMATION
 
Item 1.    Legal Proceedings                                             17
                                                               
Item 2.    Changes in Securities                                         17
                                                               
Item 3.    Defaults Upon Senior Securities                               17
                                                               
Item 4.    Submission of Matters to a Vote of Security Holders           17
                                                               
Item 5.    Other Information                                             18
                                                               
Item 6.    Exhibits and Reports on Form 8-K                              18
                                                               
           Signatures                                                    19
 
</TABLE>

                                       2
<PAGE>
 
Part I. Financial Information
Item 1. Condensed Consolidated Financial Statements

                      GENSYM CORPORATION AND SUBSIDIARIES
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                  (UNAUDITED)
<TABLE>
<CAPTION>
 
(in thousands)                                                   JUNE 30,                   DECEMBER 31,
                                                                   1998                         1997
                                                          -------------------          -------------------
<S>                                                         <C>                          <C>
ASSETS
Current Assets:
     Cash and cash equivalents                                        $13,110                      $10,958 
     Short-term investments                                             4,731                        4,843 
     Accounts receivable, net                                           7,326                        8,311 
     Prepaid expenses                                                   1,605                        1,565 
     Deferred income taxes                                              1,160                        1,160 
                                                          -------------------          -------------------
                  Total current assets                                 27,932                       26,837
                                                          -------------------          -------------------
 
 
Property and Equipment, net                                             2,355                        2,384
 
Long-term investments                                                       -                        1,041
Long-term deferred income taxes                                         1,000                        1,000
Deposits and other assets                                                 191                          255
                                                          -------------------          -------------------

                                                                      $31,478                      $31,517
                                                          ===================          ===================
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
Current Liabilities:
     Accounts payable                                                 $ 1,010                      $   914 
     Accrued expenses                                                   4,179                        4,976 
     Deferred revenue                                                   6,321                        5,799 
                                                          -------------------          -------------------
                  Total current liabilities                            11,510                       11,689
                                                          -------------------          -------------------
 
 
 
 
Stockholders' Equity:
     Common stock                                                          65                           64 
     Capital in excess of par value                                    20,188                       19,941 
     Retained earnings                                                    388                          387 
     Cumulative translation adjustment                                   (673)                        (564) 
                                                          -------------------          -------------------
                  Total stockholders' equity                           19,968                       19,828
                                                          -------------------          -------------------

                                                                      $31,478                      $31,517
                                                          ===================          ===================
 
 
</TABLE>

                The accompanying notes are an integral part of
              these condensed consolidated financial statements.

                                       3
<PAGE>
 
                              GENSYM CORPORATION
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (UNAUDITED)
 
(in thousands except per share amounts)

<TABLE> 
<CAPTION> 
                                                             THREE MONTHS ENDED                       SIX MONTHS ENDED
                                                     --------------------------------        ---------------------------------
                                                          JUNE 30,           JUNE 30,              JUNE 30,           JUNE 30,
                                                            1998               1997                  1998               1997
                                                     -------------      -------------        --------------      -------------
<S>                                                  <C>                <C>                  <C>                 <C>
REVENUES:                                           
     Product                                                $4,520            $ 3,337               $ 9,144            $ 9,269
     Service                                                 4,504              4,538                 8,964              8,637
                                                     -------------      -------------        --------------      -------------
           Total revenues                                    9,024              7,875                18,108             17,906 
                                                     -------------      -------------        --------------      -------------
                                                    
                                                    
COST OF REVENUES:                                            2,127              2,409                 4,375              4,740
                                                     -------------      -------------        --------------      -------------
                                                    
                                                    
           Gross profit                                      6,897              5,466                13,733             13,166 
                                                     -------------      -------------        --------------      -------------
                                                    
                                                    
OPERATING EXPENSES:                                 
     Sales and marketing                                     4,686              5,038                 8,949              9,749 
     Research and                                            
     development                                             1,532              1,902                 2,991              3,769    
     General and                                             
     administrative                                          1,002              1,293                 2,076              2,293 
     Restructuring                                               
     charge                                                      -              2,042                     -              2,042 
                                                     -------------      -------------        --------------      -------------
                                                             7,220             10,275                14,016             17,853
                                                     -------------      -------------        --------------      -------------
                                                    
                                                    
        Operating loss                                        (323)            (4,809)                 (283)            (4,687)
                                                    
OTHER INCOME, NET                                              171                150                   334                134
                                                     -------------      -------------        --------------      -------------
                                                    
                                                    
        Income (loss) before 
          provision for income taxes                          (152)            (4,659)                   51             (4,553)
                                                    
PROVISION FOR INCOME TAXES                                       -                  -                    50                 40
                                                     -------------      -------------        --------------      -------------
                                                    
                                                    
        Net income (loss)                                   $ (152)           $(4,659)              $     1            $(4,593) 
                                                     =============      =============        ==============      =============
                                                    
                                                    
        Basic earnings (loss) per share                     $(0.02)            $(0.74)                $0.00             $(0.73) 
                                                     =============      =============        ==============      =============
                                                    
                                                    
        Diluted  earnings  (loss) per share                 $(0.02)            $(0.74)                $0.00             $(0.73) 
                                                     =============      =============        ==============      =============
                                                    
                                                    
        Weighted average common shares outstanding           6,446              6,302                 6,431              6,262
                                                     =============      =============        ==============      =============
                                                    
                                                    
         Weighted average common shares                         
           outstanding assuming dilution                     6,446              6,302                 6,526              6,262
                                                     =============      =============        ==============      =============
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

                                       4
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (UNAUDITED)
 
 
<TABLE> 
<CAPTION> 
(in thousands)                                                                                      SIX MONTHS ENDED
                                                                                                        JUNE 30,
                                                                                       -------------------------------------
                                                                                              1998                   1997
                                                                                       --------------         --------------
<S>                                                                                    <C>                    <C>
CASH FLOWS FROM OPERATING ACTIVITIES:                                             
     Net income (loss)                                                                        $     1                $(4,593)
     Adjustments to reconcile net income (loss) to net                            
          cash provided by (used in) operating activities:                                                     
          Depreciation                                                                            592                    574
          Restructuring liability                                                                (144)                 2,019
          Changes in assets and liabilities:                                                    
             Accounts receivable                                                                  966                  1,079 
             Prepaid expenses                                                                    (124)                  (652) 
             Accounts payable                                                                     108                      8 
             Accrued expenses                                                                    (597)                (1,310) 
             Deferred revenue                                                                     530                   (390) 
                                                                                       --------------         --------------
                                                                                  
               Net cash provided by (used in) operating activities                              1,332                 (3,265)
                                                                                       --------------         --------------
                                                                                  
                                                                                  
CASH FLOWS FROM INVESTING ACTIVITIES:                                             
     Sales of short-term                                                                          112                  1,709 
     investments                                                                  
     (Purchases) sales of long-term investments                                                 1,041                   (294)
     Purchases of  property and equipment                                                        (563)                  (779) 
     (Increase) decrease in other assets                                                           68                    (75) 
                                                                                       --------------         --------------
                                                                                  
                                                                                  
         Net cash provided by investing activities                                               658                    561
                                                                                       --------------         --------------
                                                                                  
                                                                                  
CASH FLOWS FROM FINANCING ACTIVITIES:                                             
     Proceeds from exercise of stock options under stock plans                                    248                    832 
                                                                                       --------------         --------------
                                                                                  
                                                                                  
                     Net cash provided by financing activities                                    248                    832
                                                                                       --------------         --------------
                                                                                  
                                                                                  
EFFECT OF EXCHANGE RATE CHANGES ON CASH                                                           (86)                  (220)
                                                                                       --------------         --------------
                                                                                  
                                                                                  
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                            2,152                 (2,092)
                                                                                  
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                                 10,958                 11,679
                                                                                       --------------         --------------
                                                                                  
                                                                                  
CASH AND CASH EQUIVALENTS, END OF PERIOD                                                      $13,110                $ 9,587
                                                                                       ==============         ==============
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

                                       5
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)
                                        
1.  Operations

Gensym Corporation (the "Company") is a leading supplier of software products
and services for intelligent operations management in a broad range of
industries, including manufacturing, telecommunications, aerospace,
transportation, financial services, and government.

2.  Basis of Presentation

The unaudited condensed consolidated financial statements included herein have
been prepared by the Company pursuant to the rules and regulations of the
Securities and Exchange Commission (the "SEC").  Certain information and
footnote disclosures, normally included in financial statements prepared in
accordance with generally accepted accounting principles, have been condensed or
omitted pursuant to such SEC rules and regulations; nevertheless, the management
of the Company believes that the disclosures herein are adequate to make the
information presented not misleading.  In the opinion of management, the
condensed consolidated financial statements reflect all adjustments (of a normal
and recurring nature) which are necessary to present fairly the consolidated
financial position of the Company as of June 30,1998 and the results of its
operations for the three and six-month periods ended June 30,1998 and 1997 and
its cash flows for the six months then ended.  These condensed consolidated
financial statements and notes thereto should be read in conjunction with the
consolidated financial statements and notes thereto included in the Company's
Annual Report on Form 10-K filed with the SEC on March 20, 1998.  The results of
operations for the interim period are not necessarily indicative of the results
of operations for the full year.

3.  Cash Equivalents and Investments

The Company applies Statement of Financial Accounting Standards ("SFAS") No.
115, Accounting for Certain Investments in Debt and Equity Securities.
Accordingly, the Company's investments are classified as available-for-sale and
are recorded at fair value, which approximates amortized cost at June 30, 1998
and December 31, 1997.  Cash equivalents are short-term, highly liquid
investments with original maturity dates of less than three months.  Short-term
investments held as of June 30, 1998 and December 31, 1997 consist of commercial
paper and municipal bonds with original maturity dates greater than three months
that mature within one year.  Long-term investments held as of December 31, 1997
consisted of municipal bonds with maturity dates of greater than one year.

4.  Recently Issued Accounting Pronouncements

On January 1, 1998, the Company adopted American Institute of Certified Public
Accountants Statement of Position 97-2 ("SOP 97-2"), Software Revenue
Recognition.  Adoption of this pronouncement did not have a material effect on
the revenue recognition practices of the Company.

The Company adopted Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information ("SFAS No.
131"), effective January 1,1998.  SFAS No. 131 requires public companies to
report certain information about operating segments in their financial
statements, and establishes related disclosures about products and services,
geographic areas and major customers.  SFAS No. 131 does not need to be applied
to interim financial statements in the initial year of application; however,
comparative information for interim periods in the initial year of application
will be reported in the financial statements for interim periods in fiscal 1999.

                                       6
<PAGE>
 
5. Comprehensive Income

The Company adopted Statement of Financial Accounting Standards No. 130,
Reporting Comprehensive Income ("SFAS No. 130"), effective January 1, 1998.
SFAS No. 130 requires that items defined as other comprehensive income, such as
foreign currency translation adjustments, be separately classified in the
financial statements and that the accumulated balance of other comprehensive
income be reported separately from retained earnings and additional paid-in
capital in the equity section of the balance sheet.  The components of
comprehensive income for the three and six months ended June 30, 1998 and 1997
are as follows (in thousands):

<TABLE> 
<CAPTION> 
                                                 THREE MONTHS ENDED                     SIX MONTHS ENDED
                                                       JUNE 30,                              JUNE 30,
                                              -----------------------                ----------------------
                                                1998           1997                    1998           1997
                                              -------         -------                -------        -------
<S>                                            <C>            <C>                  <C>              <C> 
Comprehensive income (loss):                                                                 
  Net income (loss)                             $(152)        $(4,659)              $      1        $(4,593)
  Operating comprehensive loss foreign                                                       
    currency adjustment                           (44)           (139)                  (109)          (249)
                                              -------         -------                -------        -------
          Comprehensive                         $(196)        $(4,798)               $  (108)       $(4,842)   
                                              =======         =======                =======        =======

</TABLE> 

6.    Earnings Per Share

In accordance with SFAS No. 128, Earnings per Share, basic earnings (loss) per
share was computed by dividing net income (loss) by the weighted average number
of common shares outstanding during the three and six-month periods ended June
30, 1998 and 1997.  Diluted earnings (loss) per share for the three months ended
June 30, 1998 and 1997, and for the six months ended June 30,1997 was computed
using the weighted average number of common shares outstanding and excludes
shares issuable from assumed exercise of options, as their effect would be
antidilutive.  For the six months ended June 30, 1998, 94,413 potentially
dilutive shares were included in the computation of diluted net earnings per
share.

                                       7
<PAGE>
 
          Item 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 
                   CONDITION AND RESULTS OF OPERATIONS
                                        
OVERVIEW

  The Company was incorporated in 1986 to provide software products for
intelligent operations management. The Company's core product, G2, and G2-based
products are sold to customers for a broad array of intelligent operations
management applications in a wide range of industries, including manufacturing,
telecommunications, aerospace, transportation, financial services, and
government. In addition, the Company derives significant service revenues from
maintenance contracts, consulting services, and training courses related to its
software products.

  The Company markets and sells its products through its direct sales force in
the United States, Europe, Africa, and Asia, as well as through selected
distributors in other countries, including Japan. The Company also sells its
products through a network of value-added resellers and systems integrators,
which provide consulting services and integrated solutions to their customers.
The Company also licenses its software to OEM customers, which use it as a base
for their product offerings. The Company maintains three strategic business
units, Manufacturing, Communications, and Advanced Systems, to coordinate the
domain-specific expertise, products, and services required to serve mainstream
customers in their respective focus markets.  Gensym intends to continue to
expand the market for intelligent operations management systems by selling and
delivering tools and solutions with and through partners to large organizations
with complex operations and the potential for extensive application
proliferation.

  This Quarterly Report on Form 10-Q contains forward-looking statements.  For
this purpose, any statements contained herein that are not statements of
historical fact may be deemed to be forward-looking statements.  Without
limiting the foregoing, the words "believes," "anticipates," "plans," "expects,"
"intends" and similar expressions are intended to identify forward-looking
statements.  There are a number of important factors that could cause the
Company's actual results to differ materially from those indicated by such
forward-looking statements.  These factors include, without limitation, those
set forth below under the caption "Certain Factors That May Affect Future
Results".

                                       8
<PAGE>
 
RESULTS OF OPERATIONS

  The following table sets forth, as a percentage of total revenues,
consolidated statement of operations data for the periods indicated:




<TABLE>
<CAPTION>
                                                       THREE MONTHS ENDED                    SIX MONTHS ENDED
                                                              JUNE 30,                            JUNE 30,
                                                    ---------------------------         ---------------------------
                                                         1998             1997               1998             1997
                                                    ----------       ----------         ----------       ----------
<S>                                                   <C>              <C>                <C>              <C>
REVENUES:                                    
     Product                                              50.1%            42.4%              50.5%            51.8%
     Service                                              49.9%            57.6%              49.5%            48.2%
                                                    ----------       ----------         ----------       ----------
          Total  revenues                                100.0%           100.0%             100.0%           100.0% 
                                                    ----------       ----------         ----------       ----------

COST OF REVENUES:                                         23.6%            30.6%              24.2%            26.5%
                                                    ----------       ----------         ----------       ----------
           Gross profit                                   76.4%            69.4%              75.8%            73.5%
                                                    ----------       ----------         ----------       ----------
OPERATING EXPENSES:                          
     Sales and marketing                                  51.9%            64.0%              49.4%            54.4% 
     Research and development                             17.0%            24.2%              16.5%            21.0% 
     General and administrative                           11.1%            16.4%              11.5%            12.8% 
     Restructuring charge                                 0.0%             25.9%               0.0%            11.4% 
                                                    ----------       ----------         ----------       ----------
                                                         80.0%            130.5%              77.4%            99.7%
                                                    ----------       ----------         ----------       ----------
           Operating loss                                (3.6%)           (61.1%)             (1.6%)          (26.2%)
                                                    ----------       ----------         ----------       ----------

OTHER INCOME, NET                                         1.9%              1.9%               1.8%             0.7%
                                                    ----------       ----------         ----------       ----------
           Income (loss) before provision 
            for income taxes                             (1.7%)           (59.2%)              0.3%           (25.4%) 
                                             
PROVISION FOR INCOME TAXES                                0.0%              0.0%               0.3%             0.2%
                                                    ----------       ----------         ----------       ----------
           Net income (loss)                             (1.7%)          (59.2%)              0.0%           (25.6%) 
                                                    ==========       ==========         ==========       ==========
 
</TABLE>

                                       9
<PAGE>
 
THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997

Revenues

  The Company's revenues are derived from two sources: product licenses and
services.  Product revenues include revenues from sales of licenses for use of
the Company's software products.  Service revenues consist of fees for
maintenance contracts, consulting services, and training courses related to the
Company's products.

  Total revenues for the three and six months ended June 30, 1998 were $9.0 and
$18.1 million, respectively, an increase of 14.6% and 1.1% from $7.9 and $17.9
million in the comparable periods of fiscal 1997.  For the three-month period
ended June 30, 1998 the increase in total revenues was attributable to increased
sales of product licenses, primarily in the United States.  For the six-month
period ended June 30, 1998, the increase in total revenues was attributable to
an increase in service revenues partially offset by a decrease in product
licenses.  For the three and six months ended June 30, 1998 international
revenues accounted for 47.7% and 46.3% of total revenues, respectively, compared
to 43.6% and 46.3% of total revenues in the comparable periods of fiscal 1997.

     Product.  Product revenues for the three and six months ended June 30, 1998
were $4.5 and $9.1 million, respectively, an increase of 35.4% and a decrease of
1.4% from $3.3 and $9.3 million in the comparable periods of fiscal 1997.  The
increase in product revenues for the three-month period ended June 30, 1998
reflected higher bookings due to the effects of a more experienced sales force
and licensing agreements with several OEM customers.

  Service. Service revenues for the three and six months ended June 30, 1998
were $4.5 and $9.0 million, respectively, a decrease of 0.7% and an increase of
3.8% from $4.5 and $8.6 million in the comparable periods of fiscal 1997.  The
increase in service revenues for the six-month period ended June 30, 1998, was
primarily due to an increase in application consulting revenues and, to a lesser
extent, increased maintenance fees derived from an increased customer base.


Cost of Revenues

  Cost of revenues primarily consists of consulting labor, technical support
costs and the costs of material and labor involved in producing and distributing
the Company's software.  These costs for the three and six months ended June 30,
1998 were $2.1 and $4.4 million, respectively, a decrease of 11.7% and 7.7% from
$2.4 and $4.7 million in the comparable periods of fiscal 1997. The decrease was
primarily due to a decrease in consulting labor costs due to increased
consulting utilization.  Gross margin on revenues for the three and six months
ended June 30, 1998 was 76%, an improvement from 69% and 74% in the comparable
periods of fiscal 1997.  This increase in gross margin resulted primarily from a
higher percentage of higher margin product revenues as a percentage of total
revenues and from increased consulting utilization.


Operating Expenses

  Sales and Marketing.  Sales and marketing expenses consist primarily of costs
associated with personnel involved in the sales and marketing process, sales
commissions, sales facilities, travel and lodging, trade shows and seminars,
advertising and promotional materials. These expenses for the three and six
months ended June 30, 1998 were $4.7 and $8.9 million, respectively, a decrease
of 7.0% and 8.2% from $5.0 and $9.7 million in the comparable periods of fiscal
1997.  As a percentage of revenues, sales and marketing expenses were 51.9% and
49.4%, respectively, for the three and six months ended June 30, 1998 as
compared to 64.0% and 54.4% for the comparable periods of fiscal 1997.  The
decrease was primarily due to a reduction in certain marketing personnel and
lower facilities and leased equipment costs due to the field sales office
consolidation and other actions from the restructuring charge taken in the three
months ended June 30, 1997.  The Company intends to increase certain tactical
marketing programs and the size of the direct sales force and the related 

                                       10
<PAGE>
 
sales support personnel in the coming quarters and, as a result, expects that
sales and marketing expenses will increase on an absolute dollar basis.

  Research and Development.  Research and development expenses consist primarily
of costs of personnel, equipment, and facilities. These expenses for the three
and six months ended June 30, 1998 were $1.5 and $3.0 million, respectively, a
decrease of 19.5% and 20.6% from $1.9 and $3.8 million in the comparable periods
of fiscal 1997.  As a percentage of revenues, research and development expenses
were 17.0% and 16.5%, respectively, for the three and six months ended June 30,
1998 as compared to 24.2% and 21.0% for the comparable periods of fiscal 1997.
The decrease was primarily due to a reduction in personnel, the consolidation of
headquarter facilities, and other actions from the restructuring charge taken in
the three months ended June 30, 1997. The Company plans to add selectively to
the research and development staff during the coming quarters.

  General and Administrative.  General and administrative expenses consist
primarily of personnel costs for finance, administration, operations, and
general management, as well as legal and accounting expenses. These expenses for
the three and six months ended June 30, 1998 were $1.0 and $2.1 million,
respectively, a decrease of 22.5% and 9.5% from $1.3 and $2.3 million in the
comparable periods of fiscal 1997.  As a percentage of revenues, general and
administrative expenses were 11.1% and 11.5%, respectively, for the three and
six months ended June 30, 1998 as compared to 16.4% and 12.8% for the comparable
periods of fiscal 1997.  The decrease was primarily due to a reduction in
personnel, the consolidation of headquarter facilities, and other actions from
the restructuring charge taken in the three months ended June 30, 1997.

Other Income

  Other income consists primarily of interest income partially offset by foreign
exchange transaction gains and losses.  Other income for the three and six
months ended June 30, 1998 was $171,000 and $334,000, respectively, as compared
to $150,000 and $134,000 in the comparable periods of fiscal 1997. The increase
in the three-month period ended June 30, 1998 was primarily attributable to
increased interest income due to higher cash balances, partially offset by a
decrease in foreign exchange transaction gains and losses.  The increase in the
six-month period ended June 30, 1998 was primarily attributable to the impact of
the Company recording its 50% share in the net loss of its joint venture
investment, which was recorded in 1997.  No loss was recorded in 1998 as the
Company sold its investment in the joint venture in the third quarter of 1997.

Income Taxes

  The Company generated a tax loss carryforward during the three months ended
June 30, 1998.  Under SFAS No. 109, the Company cannot recognize a deferred tax
asset for the future benefit of its tax loss carryforward unless it concludes
that it is "more likely than not" that such deferred tax asset would be
realized.  Accordingly, the Company has established a valuation allowance
against its deferred tax asset to the extent that it cannot conclusively
demonstrate that these assets "more likely than not" will be realized.  In
determining the amount of valuation allowance required, the Company considers
numerous factors, including historical profitability, estimated future taxable
income and the volatility of its historical earnings and of the industry in
which it operates.  The Company's effective tax rate was 0% for the three-month
periods ended June 30, 1998 and 1997.  For the six-month period ended June 30,
1998, the Company's provision for income taxes primarily pertained to income
taxes in foreign jurisdictions.

LIQUIDITY AND CAPITAL RESOURCES

  The Company currently finances its operations (including capital expenditures)
primarily with cash from operations and from its current cash and short-term
investments balances.  In addition, the Company has $3.8 million of equipment
financed under long-term operating leases.  The Company's operating lease
commitments consist primarily of operating leases for the Company's facilities
and computers.

     The Company generated cash from operating activities of $1.3 million during
the first six months of 1998.  Cash generated in operations in the first six
months of 1998 was primarily due to a 

                                       11
<PAGE>
 
decrease in accounts receivable and increases in deferred revenue and accounts
payable, partially offset by a decrease in accrued expenses and an increase in
prepaid expenses. During the six-month period ended June 30, 1998 the Company's
net accounts receivable balance decreased to $7.3 million from $8.3 million.
Days sales outstanding was 73 days at June 30, 1998 compared to 79 days at both
March 31, 1998 and December 31, 1997. The Company anticipates that its days
sales outstanding may increase over the next several quarters, assuming that
revenues increase over the next several quarters.

    Investing activities provided $658,000 and $561,000 during the six-month
period ended June 30, 1998 and 1997, respectively.  The principal proceeds in
the six-month period ending June 30, 1998 were from the sale of $1.0 million in
long-term investments and $112,000 in short-term investments, partially offset
by the purchase of $563,000 in property and equipment, including a sales force
automation software system.  During the six-month period ended June 30, 1997,
the sale of short-term investments provided $1.7 million, which was offset
primarily by the purchase of $779,000 in property and equipment and the purchase
of $294,000 in long-term investments.  The Company expects that its requirements
for computers, office facilities, and office equipment will fluctuate as
staffing requirements dictate and that such equipment and facilities will be
available when needed.

    At June 30, 1998, the Company had cash, cash equivalents, and short-term
investments of $17.8 million.  The Company regularly invests excess funds in
short-term, highly rated money market funds, government securities, and
commercial paper.

     In the second quarter, the Company extended its bank line of credit on
substantially similar terms as previously arranged.  At June 30, 1998, the
Company had available a bank line of credit to borrow up to $1.0 million at an
interest rate of prime. There were no borrowings under the bank line of credit
for the period ended June 30, 1998.  This bank line of credit requires the
Company to maintain certain financial covenants.  The Company was in compliance
with all covenants contained in the bank line of credit at June 30, 1998 and
during the first six months of 1998. The bank line of credit, as extended,
expired on July 31, 1998 and the Company is in the process of negotiating the
terms of a new credit line with the bank.

    In July 1998 the Company announced that it intends to repurchase up to
650,000 shares of its common stock on the open market beginning in the third
quarter of 1998.  The Company believes that the currently available funds and
cash generated from operations will be sufficient to meet the Company's business
requirements at least through June 30, 1999.


CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS

A number of uncertainties exist that could affect the Company's operating
results, including, without limitation, the following:

Emerging Market for Intelligent Operations Management Systems.  Substantially
all of the Company's revenues are derived from the licensing and support of
software products that enable organizations to implement intelligent operations
management systems.  Although many organizations have begun to deploy, or have
announced plans to deploy, intelligent operations management systems, these
systems are different from the basic monitoring and control systems that are
traditionally employed by these organizations.  There can be no assurance that
these organizations will be able to introduce intelligent operations management
systems successfully nor that such systems will gain widespread acceptance.  In
addition, the timing of the implementation of intelligent operations management
systems by organizations may be affected by economic factors, government
regulations, and other factors.  Delays in the introduction of intelligent
operations management systems or the failure of these systems to gain widespread
market acceptance would materially and adversely affect the Company's business,
results of operations, or financial condition.  In addition, the Company
believes that end-users in its markets are increasingly seeking complete
solutions, rather than software tools with which to develop such solutions.
Meeting this demand has required the Company to modify its sales approach.  The
Company is also increasingly reliant on value-added resellers and systems
integrators to deliver services to implement these solutions.  The modified
sales approach may also lengthen the Company's average sales cycle.  Failure by
the Company to respond appropriately to

                                       12
<PAGE>
 
lengthen the Company's average sales cycle. Failure by the Company to resond
appropriately to shifts in market demand could have a material adverse effect on
the Company's business, results of operations, or financial condition.

Dependence Upon Development of Sales and Marketing Force. The Company's future
success will depend, in part, upon the productivity of its sales and marketing
force and the ability of the Company to continue to attract, integrate, train,
motivate and retain new sales and marketing personnel.  There can be no
assurance that the Company's investment in sales and marketing will ultimately
prove to be successful.  In addition, there can be no assurance that the
Company's sales and marketing organization will be able to compete successfully
against the significantly more extensive and better funded sales and marketing
operations of many of the Company's current and potential competitors.  The
Company's inability to manage its sales and marketing force effectively could
have a material adverse effect on the Company's business, operating results and
financial condition.

Variability of Quarterly Operating Results.  The Company has experienced, and
may experience in the future, significant quarter-to-quarter fluctuations in its
operating results.  The Company has, on occasion, recorded quarterly losses, and
there can be no assurance that revenue growth or profitable operations can be
attained on a quarterly or annual basis in the future.  The Company's sales
cycle typically ranges from six to 12 months, and the cost of acquiring the
Company's software, building and deploying applications, and training users
represents a significant expenditure for customers.  The Company's relatively
long sales cycle and high license fees, together with fixed short-term expenses,
can cause significant variations in operating results from quarter to quarter,
based on a relatively small variation in the timing of major orders.  Factors
such as the timing of new product introductions and upgrades and the timing of
significant orders could contribute to this quarterly variability.  In addition,
the Company ships software products within a short period after receipt of an
order and typically does not have a material backlog of unfilled orders of
software products.  Therefore, revenues from software licenses in any quarter
are substantially dependent on orders booked in that quarter.  Historically, a
majority of each quarter's revenues from software licenses has come from license
contracts that have been effected in the final weeks of that quarter.  The
revenues for a quarter typically include a number of large orders.  If the
timing of any of these orders is delayed, it could result in a substantial
reduction in revenues for that quarter.  The Company's expense levels are based
in part on expectations of future revenue levels.  A shortfall in expected
revenues could therefore result in a disproportionate decrease in the Company's
net income.  The Company's financial performance has generally been somewhat
weaker in the first quarter than in the other fiscal quarters, due to customer
purchasing patterns.

Economic Factors and Industry Concentration.  Because capital expenditures are
often viewed as discretionary by organizations, sales of the Company's products
for capital budget projects are subject to general economic conditions.  Such
capital expenditures are also susceptible to industry-specific economic
downturns. Specifically, the Company derives a significant portion of its
revenues from the chemical and petrochemical industries.  The Company derived
19.7%, 26.8%, and 15.6% of its product revenues in the chemical and
petrochemical industries in 1996, 1997 and the first six months of 1998,
respectively.  Accordingly, the Company's future success is dependent upon the
continued demand for process control and optimization software from companies in
the chemical and petrochemical industries.  The Company believes that economic
downturns and pricing pressures experienced by chemical and petrochemical
companies in connection with cost-containment measures have led to delays and
reductions in certain capital and operating expenditures by many of such
companies worldwide.  These industries are highly cyclical and have experienced
weakened demand in the past, which has adversely affected the Company's
revenues, gross margin, and operating results during such periods. Future
recessionary conditions in the industries which use the Company's products may
adversely affect the Company's business, results of operations, or financial
condition.

Product Concentration.  The Company's only current product offerings are G2, an
object-oriented development and deployment environment for building intelligent
operations management systems, and software application products which operate
in conjunction with G2.  Accordingly, the Company's business and financial
results are substantially dependent upon the continued customer acceptance and
deployment of G2 and related products.  The timing of major G2 releases may
affect the timing of purchases of the Company's products.  The Company has
introduced several G2-based products for

                                       13
<PAGE>
 
building applications and is developing others. The Company believes that market
acceptance of these products will be important to the Company's future growth.
There can be no assurance that such products will achieve market acceptance or
that new products will be successfully developed. In addition, the Company
relies on many of its marketing partners to develop G2-based products for
specialized markets. Accordingly, the Company's business and financial results
are also linked to the continued successful product development by its marketing
partners and market acceptance of such G2-based products. Any decline in the
demand for G2 and related products, whether as a result of competitive products,
price competition, the lack of success of the Company's marketing partners,
technological change, the shift in customer demand toward complete solutions, or
other factors, could have a material adverse effect on the Company's business,
results of operations, or financial condition.

New Products and Rapid Technological Change.  The market for the Company's
products is relatively new and is characterized by rapid technological change,
evolving industry standards, changes in end-user requirements, and frequent new
product introductions and enhancements.  The Company's future success will
depend in part upon its ability to enhance its existing products, to introduce
new products and features to meet changing customer requirements and emerging
industry standards, and to manage transitions from one product release to the
next.  The Company anticipates releasing new client access and object exchange
products in the second half of 1998.  The Company has from time to time
experienced delays in introducing new products and product enhancements.  There
can be no assurance that the Company will not experience difficulties that could
delay or prevent the successful development, introduction and marketing of these
new products and product enhancements. Also there can be no assurance that the
Company will successfully complete the development of new or enhanced products,
that the Company will successfully manage the transition to future versions of
G2, or that the Company's future products will achieve market acceptance.  In
addition, the introduction of products embodying new technologies and the
emergence of new industry standards could render the Company's existing products
and products currently under development obsolete and unmarketable.  From time
to time, new products, capabilities, or technologies may be announced that have
the potential to replace or shorten the life cycle of the Company's existing
product offerings.  There can be no assurance that announcements of currently
planned or other new product offerings will not cause customers to defer
purchasing existing Company products.  See "Emerging Market for Intelligent
Operations Management Systems".

Migration to Microsoft Windows and Object Exchange Standards.  The Company
believes that client user interfaces compliant with Microsoft Windows and MOTIF
are increasingly the preferred choice of its customers.  In order to gain wider
customer penetration, the Company must respond to this market choice.  The
Company is developing its next client access product to be Microsoft Windows and
MOTIF compliant.  There can be no assurance that the Company will be successful
in developing and marketing this new product.  Any delay or failure to bring
this product to market could affect the Company's competitive position or limit
its growth opportunities.

Reliance Upon Indirect Distribution Channels and Risks Associated with Strategic
Partner Relationships.  The Company sells its products in part through value-
added resellers, systems integrators, OEMs, and distributors, who are not under
the control of the Company.  Sales of the Company's products by value-added
resellers, systems integrators and OEMs represented 28%, 35% and 32% of the
Company's product revenues in 1996, 1997 and the first six months of 1998,
respectively.  Sales of the Company's products by distributors, primarily the
Company's Japanese distributor, accounted for 14%, 8% and 3% of the Company's
product revenues in 1996, 1997 and the first six months of 1998, respectively.
The loss of one or more major third-party distributors, OEMs or resellers of the
Company's products, a significant decline in their sales, or difficulty on the
part of such third-party developers or resellers in developing successful G2-
based products and applications could have a material adverse effect on the
Company's business, results of operations, or financial condition.

A significant business strategy of the Company is to add resources for channel
business development and management and to expand its relationship with
strategic partners.  There can be no assurance that the Company will be able to
negotiate additional strategic partner relationships on acceptable terms or that
any such relationships, if established, will be commercially successful.  There
also can be no assurance that existing or potential partners will not pursue
alternative technologies or develop

                                       14
<PAGE>
 
alternative products in addition to or in lieu of the Company's products either
on their own or in collaboration with others, including the Company's
competitors. In addition, the Company relies on third-party resellers to provide
post-sales service and support to its customers, and any deficiencies in such
service and support could adversely affect the Company's business, results of
operations, or financial condition.

Risks Associated With International Operations.  The Company's international
revenues represented 42%, 46% and 46% of total revenues in 1996, 1997 and the
first six months of 1998, respectively.  Revenues are categorized by the Company
according to product shipment destination and therefore do not necessarily
reflect the ultimate country of installation.  The international portion of the
Company's business is subject to a number of inherent risks, including
difficulties in building and managing international operations, difficulties in
localizing products and translating documentation into local languages,
fluctuations in the value of international currencies, fluctuating import/export
duties and quotas, and unexpected regulatory, economic, or political changes in
international markets.  The Company derives a portion of its international
revenues from customers in Asia, including customers in Japan.  Currency
fluctuations and instability in Asian financial markets may reduce potential
customers' investment in capital projects which utilize the software products
developed and marketed by the Company and its partners.  There can be no
assurance that these factors will not adversely affect the Company's business,
results of operations, or financial condition.

Competition.  Although the Company believes that there are no other commercially
available products that offer the full range of high-level capabilities embodied
in the Company's products, a number of companies offer products that perform
certain functions of G2 for specific applications. In all of the Company's
markets, there is competition from "point solutions", real-time and expert
system products and internally developed software.  At the fundamental level,
there are commercially available software development tools that software
application developers or potential customers could use to build software having
functionality similar to the Company's products.

Certain companies such as Objective Systems Integrators, Inc. and Pavilion sell
"point solutions" that compete with the Company's products with respect to
specific applications or uses. Several companies including Comdale Technologies
and Ilog S.A. offer products with limited real-time or expert system development
capabilities at lower price points than those provided by the Company.  These
products often require extensive programming with languages such as C or C++ for
complete implementation.  Although the Company believes that these products
offer a less productive development environment than G2 and that they lack the
comprehensive capabilities of G2-based products, certain competitors in this
category have greater financial and other resources than the Company and might
introduce new or improved products to compete with G2, possibly at lower prices.

The Company's software is integrated into industry-specific solutions by value-
added resellers.  A number of software companies offer products that compete in
specific application areas addressed by these value-added resellers, such as
cement kiln control and refinery scheduling, and they could be successful in
supplying alternatives to products based on the Company's software.

Many of the Company's customers have significant investments in their existing
solutions and have the resources necessary to enhance existing products and to
develop future products.  These customers may develop and incorporate competing
technologies into their systems or may outsource responsibility for such systems
to others who do not use the Company's products.  There can be no assurance that
the Company can successfully persuade development personnel within these
customers' organizations to use G2-based products that can cost effectively
compete with their internally developed products.  This would reduce the need
for the Company's products and services and limit future opportunities for the
Company.

The Company believes that continued investment in research and development and
sales and marketing will be required to maintain its competitive position.
There can be no assurance that competitors will not develop products or provide
services that are superior to the Company's products or services or achieve
greater market acceptance.  Competitive pressures faced by the Company could
force the Company to reduce its prices, which could result in reduced
profitability.  There can be no assurance that the Company will be able to
compete successfully against current and future

                                       15
<PAGE>
 
sources of competition or that such competition will not have a material adverse
effect on the Company's business, results of operations, or financial condition.

Potential for Undetected Errors.  Complex software products such as those
offered by the Company may contain unintended errors or failures commonly
referred to as "bugs".  There can be no assurance that, despite significant
testing by the Company and by current and potential customers, errors will not
be found in new products after commencement of commercial shipments.  Although
the Company has not experienced material adverse effects resulting from any such
errors or defects to date, there can be no assurance that errors or defects will
not be discovered in the future that could cause delays in product introduction
and shipments or require design modifications that could adversely affect the
Company's business, results of operations, or financial condition.

Dependence Upon Proprietary Technology.  The Company's success is heavily
dependent upon its proprietary technology.  The Company relies upon a
combination of trade secret, contract, copyright, patent, and trademark law to
protect its proprietary rights in its products and technology. The Company
enters into confidentiality and/or license agreements with its employees, third-
party resellers, and end-users and limits access to and distribution of its
software, documentation, and other proprietary information.  In addition, the
Company has placed technical inhibitors in its software that prevent such
software from running on unauthorized computers.  However, effective patent,
copyright, and trade secret protection may not be available in every country in
which the Company's products are distributed.  There can be no assurance that
the steps taken by the Company to protect its proprietary technology will be
adequate to prevent misappropriation of its technology by third parties, or that
third parties will not be able to develop similar technology independently.  In
addition, there can be no assurance that third parties will not assert
infringement claims in the future or that such claims will not be successful.

Dependence on Key Personnel.  The Company's success depends in large part upon
certain key employees, including its executive officers, the loss of any of whom
could have a material adverse effect on the Company.  In particular, the Company
hired three new executive officers in 1997, resulting in a significant
percentage of key personnel having approximately one year of experience with the
Company.  The Company's key employees are not bound by employment agreements
that require them to remain with the Company.  The Company's success will depend
in significant part upon its ability to attract and retain highly-skilled
management, technical, and sales and marketing personnel.  Competition for such
personnel in the software industry is intense, and there can be no assurance
that the Company will be successful in attracting and retaining such personnel,
or that new key personnel will integrate successfully into the senior management
team. The loss of certain key employees or the Company's inability to attract
and retain other qualified employees or to adequately replace key personnel who
depart the Company could have a material adverse effect on the Company's
business, results of operations, or financial condition.

Year 2000 Compliance.  Many installed computer systems and software products are
coded to accept only two digit entries in the date code field.  Beginning in the
year 2000, these date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates.  Systems that do not
properly recognize such information could generate erroneous data or cause a
system to fail.  Although the Company believes that its products and systems are
Year 2000 compliant, the Company utilizes third party equipment and software
that may not be Year 2000 compliant.  Failure of such third party equipment or
software to operate properly with regard to the Year 2000 and thereafter could
require the Company to incur unanticipated expenses to remedy any problems,
which could have a material adverse effect on the Company's business, operating
results and financial condition.  Furthermore, the purchasing patterns of
customers or potential customers may be affected by Year 2000 issues as
companies expend significant resources to correct their current systems for Year
2000 compliance.  These expenditures may result in reduced funds available to
purchase products and services such as those offered by the Company.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

    Not Applicable

                                       16
<PAGE>
 
PART II - OTHER INFORMATION


ITEM 1.  LEGAL PROCEEDINGS

         None

ITEM 2.  CHANGES IN SECURITIES

         None

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         None

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

On May 20, 1998 the Company held its Annual Meeting of the Stockholders. The
following matters were adopted by the vote specified below:

<TABLE>
<CAPTION>
                                                                                   Authority
      Proposal                             Class of Stock           For            Withheld
      --------                             --------------       ----------------  ---------------
<S>                                        <C>                  <C>               <C>              <C>
1)    Approval of election of
      two Class II Directors to
      the Board of Directors for
      the ensuing three years
 
      Lowell B. Hawkinson                  Common Stock                5,021,084           41,266
      Theodore G. Johnson                  Common Stock                5,021,184           41,166
 <CAPTION> 
      Proposal                             Class of Stock             For             Against          Abstain
      --------                             -------------------  ----------------  ---------------  ----------------
<S>                                        <C>                  <C>               <C>              <C>
2)    Adoption of amendment to the         Common Stock                4,993,151           55,155            14,044
      1995 Employee Stock Pur-
      chase Plan to increase the
      number of shares reserved from
      200,000 shares to 500,000 shares
<CAPTION> 
      Proposal                             Class of Stock             For             Against          Abstain
      --------                             -------------------  ----------------  ---------------  ----------------
<S>                                        <C>                  <C>               <C>              <C>
3)    Approval of appointment              Common Stock                5,039,914           16,986             5,450
      by the Board of Directors
      of Arthur Andersen LLP
      as independent auditors
      for the current year
</TABLE>
<PAGE>
 
ITEM 5.  OTHER INFORMATION

Stockholder Proposals
---------------------

          Stockholder proposals submitted pursuant to Rule 14a-8 under the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), and intended
to be presented at Company's 1999 Annual Meeting of Stockholders must be
received by the Company not later than December 9, 1998 in order to be
considered for inclusion in the Company's proxy materials for that meeting.

          The Company's By-Laws (the "By-Laws") also establish advance notice
procedures with respect to a stockholder nomination of candidates for election
as Directors (a "Director Nomination") and for the conduct of other business to
be brought before an annual meeting by a stockholder ("Other Business") not
submitted pursuant to Rule 14a-8.  A notice regarding a Director Nomination or a
proposal for Other Business must be received by the Company not less than 60
days nor more than 90 days prior to the applicable stockholder meeting,
provided, however, that in the event that less than 70 days' notice or prior
disclosure of the date of the meeting is given or made to the Company's
stockholders, the notice must be received by the company not later than the
tenth day following the date on which such notice of the date of the meeting was
mailed or such public disclosure was made, whichever occurs first.  Any such
notice must contain certain specified information concerning the persons to be
nominated and/or the Other Business and the stockholder submitting the Director
Nomination or proposal for Other Business not made in compliance with such
advance notice requirements.  The Company has not yet publicly announced the
date of the 1999 Annual Meeting. The advance notice provisions of the Company's 
bylaws supersede the notice requirements contained in recent amendments to Rule 
14a-4 under the Exchange Act.

          Director Nominations or stockholder proposals for Other Business
should be mailed to Secretary, Gensym Corporation, 125 CambridgePark Drive,
Cambridge, Massachusetts 02140.

Recent Development
------------------

The Company announced on August 6, 1998 that Richard M. Darer, Senior Vice
President of Finance and Administration and Chief Financial Officer, will be
resigning his position effective August 28, 1998.

ITEM 6.  EXHIBITS AND REPORTS OF FORM 8-K

     (a)   Exhibit Index
           Exhibit 10.1 - 1995 Employee Stock Purchase Plan, as amended
           Exhibit 27 - Financial Data Schedule

     (b)  No reports on Form 8-K were filed by Gensym during the quarter ended
          June 30, 1998.
<PAGE>
 
                                   SIGNATURES


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



                                            GENSYM CORPORATION
                                               (Registrant)



                                            /s/ Lowell B. Hawkinson
                                            -----------------------
       Dated:  August 10, 1998              Lowell B. Hawkinson
                                            Chief Executive Officer
                                            (Principal Executive Officer)


                                            /s/ Richard M. Darer
                                            --------------------
       Dated:  August 10, 1998              Richard M. Darer
                                            Senior Vice President of Finance and
                                            Administration, and Chief Financial
                                            Officer (Principal Financial and
                                            Accounting Officer)