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UNITED STATES

SECURITIES AND
EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q





(Mark one)



x  Quarterly report pursuant to Section 13 or 15(d) of the

Securities Exchange Act of
1934



For the quarterly period ended June 30, 2003



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.)





52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)





Telephone Number (781) 265-7100

(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 ̈



Indicate by checkmark whether the registrant is an accelerated filer (as
defined in Rule 12-b-2 of the Exchange Act)



Yes ̈No  x



As of August 12, 2003 there were 7,011,408 shares of the Registrants
Common Stock outstanding.





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PART I.  FINANCIAL INFORMATION



ITEM 1.    Consolidated Financial Statements



GENSYM CORPORATION



CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share
amounts)



|                                                                                                                         |  | June 30, |         |   | December 31, |  
|------------------------------------------------------------------------------------------------------------------------ |  | -------- | ------- | - | ------------ | -
|                                                                                                                         |  | 2003     |         |   | 2002         |  
|ASSETS                                                                                                                   |  |          |         |   |              |  
|Current Assets:                                                                                                          |  |          |         |   |              |  
|Cash and cash equivalents                                                                                                |  | $        | 2,969   |   |              | $
|Accounts receivable, net                                                                                                 |  |          | 2,278   |   |              |  
|Prepaid and other current assets                                                                                         |  |          | 1,128   |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Total current assets                                                                                                     |  |          | 6,375   |   |              |  
|Property and equipment, net                                                                                              |  |          | 1,176   |   |              |  
|Intangible assets                                                                                                        |  |          | 229     |   |              |  
|Other assets                                                                                                             |  |          | 506     |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Total Assets                                                                                                             |  | $        | 8,286   |   |              | $
|                                                                                                                         |  |          |         |   |              |  
|                                                                                                                         |  |         
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                     |  |          |         |   |              |  
|Current Liabilities:                                                                                                     |  |          |         |   |              |  
|Current portion of capital lease obligation                                                                              |  |          | 113     |   |              |  
|Accounts payable                                                                                                         |  |          | 297     |   |              |  
|Accrued expenses                                                                                                         |  |          | 2,027   |   |              |  
|Restructuring                                                                                                            |  |          | 250     |   |              |  
|Deferred revenue                                                                                                         |  |          | 4,685   |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Total current liabilities                                                                                                |  |          | 7,372   |   |              |  
|Long-term deferred revenue                                                                                               |  |          | 434     |   |              |  
|Other long-term liabilities                                                                                              |  |          | 71      |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Total liabilities                                                                                                        |  |          | 7,877   |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Stockholders Equity                                                                                                     |  |          |         |   |              |  
|Preferred stock, $.01 par value Authorized2,000,000 shares; issued and outstandingnone                                |  |          |        |   |              |  
|Common stock, $.01 par value Authorized20,000,000 shares; issued7,420,695 shares in 2003 and 7,315,949 shares in
2002 |  |          |         |   |              |  
|Outstanding6,998,058 shares in 2003 and 6,850,606 in 2002                                                               |  |          | 74      |   |              |  
|Capital in excess of par value                                                                                           |  |          | 21,842  |   |              |  
|Treasury stock422,637 shares in 2003 and 465,343 shares in 2002, at cost                                                |  |          | (1,576  | ) |              |  
|Accumulated deficit                                                                                                      |  |          | (20,027 | ) |              |  
|Accumulated other comprehensive income (loss)                                                                            |  |          | 96      |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Total stockholders equity                                                                                               |  |          | 409     |   |              |  
|                                                                                                                         |  |          |         |   |              |  
|Total liabilities and stockholders equity                                                                               |  | $        | 8,286   |   |              | $
|                                                                                                                         |  |          |         |   |              |  



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



2



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GENSYM CORPORATION



CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)



|                                                                     |  | Three months endedJune 30, |        | Six months endedJune 30,
|-------------------------------------------------------------------- |  | -------------------------- | ------ | ------------------------
|                                                                     |  | 2003                       |        |                         
|Revenues                                                             |  |                            |        |                         
|Product                                                              |  | $                          | 958    |                         
|Services                                                             |  |                            | 2,392  |                         
|                                                                     |  |                            |        |                         
|Total revenues                                                       |  |                            | 3,350  |                         
|                                                                     |  |                            |        |                         
|Cost of revenues                                                     |  |                            |        |                         
|Product                                                              |  |                            | 222    |                         
|Services                                                             |  |                            | 777    |                         
|                                                                     |  |                            |        |                         
|Total cost of revenues                                               |  |                            | 999    |                         
|                                                                     |  |                            |        |                         
|Gross profit                                                         |  |                            | 2,351  |                         
|                                                                     |  |                            |        |                         
|Operating expenses                                                   |  |                            |        |                         
|Sales and marketing                                                  |  |                            | 1,376  |                         
|Research and development                                             |  |                            | 816    |                         
|General and administrative                                           |  |                            | 1,081  |                         
|Restructuring charge                                                 |  |                            | 250    |                         
|                                                                     |  |                            |        |                         
|Total operating expenses                                             |  |                            | 3,523  |                         
|                                                                     |  |                            |        |                         
|Operating income (loss)                                              |  |                            | (1,172 | )                       
|                                                                     |  |                            |        |                         
|Other income (expense), net                                          |  |                            | 86     |                         
|                                                                     |  |                            |        |                         
|Income (loss) before provision for income taxes                      |  |                            | (1,086 | )                       
|                                                                     |  |                            |        |                         
|Provision for income taxes                                           |  |                            | 102    |                         
|                                                                     |  |                            |        |                         
|Net income (loss)                                                    |  | $                          | (1,188 | )                       
|                                                                     |  |                            |        |                         
|Net income (loss) per share:                                         |  |                            |        |                         
|Basic                                                                |  | $                          | (0.17  | )                       
|Diluted                                                              |  | $                          | (0.17  | )                       
|                                                                     |  |                            |        |                         
|Weighted average shares used to compute Net income (loss) per share: |  |                            |        |                         
|Basic                                                                |  |                            | 6,920  |                         
|Diluted                                                              |  |                            | 6,920  |                         



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



3



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GENSYM CORPORATION



CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                                   |  | Six months endedJune 30, |       
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ------
|                                                                                                   |  | 2003                     |       
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                              |  |                          |       
|Net (loss) income                                                                                  |  | $                        | (1,824
|Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: |  |                          |       
|Depreciation and amortization                                                                      |  |                          | 350   
|Loss on disposal of equipment                                                                      |  |                          | 26    
|Provision for bad debt                                                                             |  |                          | 9     
|Issuance of treasury shares                                                                        |  |                          | 36    
|Changes in assets and liabilities:                                                                 |  |                          |       
|Accounts receivable                                                                                |  |                          | 1,634 
|Other assets                                                                                       |  |                          | (257  
|Accounts payable                                                                                   |  |                          | 10    
|Accrued expenses                                                                                   |  |                          | (528  
|Restructuring                                                                                      |  |                          | 250   
|Deferred revenue                                                                                   |  |                          | (264  
|                                                                                                   |  |                          |       
|Net cash (used in) provided by operating activities                                                |  |                          | (558  
|                                                                                                   |  |                          |       
|                                                                                                   |  |                         
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                              |  |                          |       
|Purchases of property and equipment                                                                |  |                          | (279  
|Purchase of intangible assets                                                                      |  |                          | (250  
|                                                                                                   |  |                          |       
|Net cash used in investing activities                                                              |  |                          | (529  
|                                                                                                   |  |                          |       
|                                                                                                   |  |                         
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                              |  |                          |       
|Borrowings under capital lease arrangements                                                        |  |                          | 54    
|Principal payments on capital lease obligations                                                    |  |                          | (35   
|Proceeds from exercise of stock options and issuance of common stock under stock plans             |  |                          | 49    
|                                                                                                   |  |                          |       
|Net cash provided by financing activities                                                          |  |                          | 68    
|                                                                                                   |  |                          |       
|                                                                                                   |  |                         
|EFFECT OF EXCHANGE RATE CHANGES ON CASH                                                            |  |                          | 104   
|                                                                                                   |  |                          |       
|                                                                                                   |  |                         
|NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                                               |  |                          | (915  
|                                                                                                   |  |                         
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                                     |  |                          | 3,884 
|                                                                                                   |  |                          |       
|                                                                                                   |  |                         
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                                           |  | $                        | 2,969 
|                                                                                                   |  |                          |       



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



4



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GENSYM CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



1.    Operations



We are a
provider of operations management and expert systems software products and services. Our products emulate the reasoning of human experts using process knowledge and often real-time data and then, on the basis of such reasoning, make recommendations
or take direct operational actions. Most applications of our products are in the areas of abnormal condition management in manufacturing environments, supply chain and logistics management, and network management. Benefits derived from the use of
our products include waste reduction, avoidance of off-specification product, avoidance of system down time in mission-critical networks, and proactive alarms that signify potential process problems and avoid plant shut downs. Our products have been
used in the chemical, oil and gas, manufacturing, transportation, communications, aerospace and government sectors for many years.



2.    Basis of Presentation



The unaudited 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) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements prepared for the full year in accordance with accounting principles generally
accepted in the United States of America, 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 consolidated financial statements reflect all adjustments (of a normal and recurring nature) that are necessary to present fairly the consolidated financial position of the Company as of June 30, 2003
and the results of its operations for the three and six month periods ended June 30, 2003 and 2002. These consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto
included in our Annual Report on Form 10-K for the year ended December 31, 2002, filed with the SEC on March 31, 2003. The results of operations for interim periods are not necessarily indicative of the results of operations for the full year or any
other interim period. Certain prior period amounts have been reclassified to conform with the current period presentation.



We achieved operating and overall profitability as well as positive cash flows for the year ended December 31, 2002. Previously, we had incurred operating
losses for both the years ended December 31, 2001 and 2000. We have incurred an operating loss in the six months ended June 30, 2003 as a result of declining revenues, primarily in the chemical, oil and gas markets, which are a significant component
of our business and have been adversely affected by the situation in the Middle East. In addition, generally poor economic conditions in Europe have resulted in a decline in new orders from many old as well as new customers. We achieved
profitability in 2002 based on expense control, cost reductions completed in 2001 and maintaining revenues from existing sales of licenses. The benefits of our expense control and cost reduction actions have continued in 2003; however, license sales
have declined, which has contributed to our net losses in the first and second quarters of 2003. We will continue to pursue new license sales to generate additional product revenue in 2003 and believe that our current cash and cash equivalent
balances and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least the next 12 months.



3.    Comprehensive Income (Loss )



The components of comprehensive income (loss) for the three and six-month periods ended June 30, 2003 and 2002 are as
follows (in thousands):



|                                        |  | Three months endedJune 30, |        | Six months endedJune 30,
|--------------------------------------- |  | -------------------------- | ------ | ------------------------
|                                        |  | 2003                       |        |                         
|Net income (loss)                       |  | $                          | (1,188 | )                       
|Other comprehensive income (loss):      |  |                            |        |                         
|Foreign currency translation adjustment |  |                            | 47     |                         
|                                        |  |                            |        |                         
|Comprehensive income (loss)             |  | $                          | (1,141 | )                       
|                                        |  |                            |        |                         





5



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4.    Net Income (Loss) Per Share



The following is a reconciliation of basic and diluted weighted average
shares used in the computation of net income (loss) per share (in thousands):



|                                             |  | Three monthsended June 30, |  | Six monthsended June 30,
|-------------------------------------------- |  | -------------------------- |  | ------------------------
|                                             |  | 2003                       |  | 2002                    
|Weighted average common shares outstanding   |  | 6,920                      |  | 6,691                   
|Additional dilutive common stock equivalents |  |                           |  | 370                     
|                                             |  |                            |  |                         
|Diluted weighted average shares              |  | 6,920                      |  | 7,061                   
|                                             |  |                            |  |                         



Options to purchase
471,000 shares of common stock with an exercise price between $0.81 and $10.00 per share were outstanding in the second quarter of 2002, and options to purchase 521,000 shares of common stock with an exercise price between $0.78 and $10.00 per share
were outstanding in the six-month period ended June 30, 2002 but were excluded from the computation of diluted earnings per share because such options were anti-dilutive in the respective periods. All options to purchase a total of 1,362,890 shares
of common stock were outstanding for each of the three- and six-month periods ended June 30, 2003, but were excluded from the computation of diluted earnings per share because such options were anti-dilutive as we had net losses in those periods.



5.    Stock Based Compensation



We follow the disclosure requirements of Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure  an amendment of SFAS No. 123. We continue to recognize compensation
costs using the intrinsic value based method described in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.



Net income (loss) and net income (loss) per share as reported in these consolidated financial statements on a pro forma basis, as if the fair value based
method described in SFAS No. 123 had been adopted, are as follows:



|(in thousands except per share data)          |  | Three months endedJune 30, |   | Six months endedJune 30,
|--------------------------------------------- |  | -------------------------- | - | ------------------------
|                                              |  | 2003                       |   |                         
|Net income (loss) as reported                 |  | $(1,188                    | ) |                         
|Stock based compensation expense              |  | 41                         |   |                         
|                                              |  |                            |   |                         
|Pro forma net income (loss)                   |  | $(1,229                    | ) |                         
|                                              |  |                            |   |                         
|Basic earnings (loss) per share as reported   |  | $(0.17                     | ) |                         
|Diluted earnings (loss) per share as reported |  | $(0.17                     | ) |                         
|                                              |  |                            |   |                         
|Pro forma basic (loss) earnings per share     |  | $(0.18                     | ) |                         
|Pro forma diluted (loss) earnings per share   |  | $(0.18                     | ) |                         



6.    Intangible assets



On March 12, 2003, we acquired certain intellectual property from Key Control, Inc. This intellectual property comprises intelligent objects for embedding in process management applications. In connection with the acquisition, we agreed to
pay $250,000 under deferred payment terms. Payments made through June 30, 2003 amounted to $207,683. All payments will be made by September 30, 2003.



6



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7.    Segment Reporting



Revenue is presented geographically based on the country to where the product is shipped or where the services are provided.
The following table presents revenues by geographic area:



|               |  | Three months endedJune 30, |  | Six months endedJune 30,
|-------------- |  | -------------------------- |  | ------------------------
|               |  | 2003                       |  | 2002                    
|United States  |  | 49%                        |  | 48%                     
|United Kingdom |  | 6%                         |  | 14%                     
|Rest of Europe |  | 25%                        |  | 20%                     
|Rest of World  |  | 20%                        |  | 18%                     



The following table
presents the Companys long-lived assets, net of depreciation and amortization, as of June 30, 2003 and December 31, 2002 (in thousands):



|              |  | June 30,2003 |       | December 31,2002
|------------- |  | ------------ | ----- | ----------------
|United States |  | $            | 1,188 |                 
|Europe        |  |              | 217   |                 
|              |  |              |       |                 
|Total         |  | $            | 1,405 |                 
|              |  |              |       |                 



8.    Guarantor Arrangements



In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a
guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002, while the disclosure requirements are applicable in 2002. We have adopted FIN No. 45, and the adoption of FIN No. 45 did not have a material impact on our financial position
or results of operations.



The following is a summary of our
agreements that the Company has determined are within the scope of FIN No. 45:



As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity.
The term of the indemnification period is for the officers or directors lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a
Director and Officer insurance policy that limits its exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is
minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, we believe that our liabilities for these agreements as of June 30, 2003 are
immaterial.



We enter into standard indemnification agreements
in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in
connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the
agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification
agreements. As a result, we believe the estimated fair value of future payments under these agreements is minimal. Accordingly, we believe our liabilities for these agreements as of June 30, 2003 are immaterial.





7



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9.    Restructuring Charges



In June 2003, the Companys board of directors approved a workforce reduction plan. Given the uncertain economic
conditions, the Company has decided to take certain actions to reduce its expenses to a level that is commensurate with current levels of revenue. As a result of implementation of this plan, the Company recorded a restructuring charge of $250,000 in
the second quarter of 2003. The charge is based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe and
related legal costs. No amounts were paid prior to June 30, 2003, however the Company expects to complete the plan by March 31, 2004. Some of the impact of the actions will be realized immediately, and the Company expects that additional savings
will be realized by December 31, 2003.



10.    Recent
Accounting Pronouncements



In May 2003, the FASB issued
Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity SFAS No. 150. This statement affects the classification, measurement and disclosure
requirements of the following three types of freestanding financial instruments: 1) mandatorily redeemable shares, which the issuing company is obligated to buy back with cash or other assets; 2) instruments that do or may require the issuer to buy
back some of its shares in exchange for cash or other assets, which includes put options and forward purchase contracts; and 3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a
variable such as a market index, or varies inversely with the value of the issuers shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning
after June 15, 2003. The Company does not expect SFAS No. 150 to have an impact on its financial statements.



8



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ITEM 2.    MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Forward-Looking Statements



This quarterly report contains forward-looking statements and information
relating to us and our subsidiaries, which are based on managements beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. When used herein, words such as anticipate, believe, estimate, expect, intend and similar expressions, as they relate to us or our
management identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth below
under the caption Factors Affecting Future Operating Results. Should one or more of these risks or uncertainties materialize, or should underlying assumption prove incorrect, actual results may vary materially from those described in
this report as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or
revise any forward-looking statements.



Business Overview



We were incorporated in Delaware in 1986 to develop and sell software
products for expert operations management. Our flagship product has been, and continues to be, G2, which can emulate the reasoning of human experts as they assess, diagnose and respond to unusual operating situations or as they seek to optimize
operations. We have also developed a number of market-specific products using G2 as a platform. Since our inception, we have sold over 15,000 licenses to customers in a variety of industries.



Over the years we have developed and improved G2 and its related products on
a regular basis, in terms of performance, functionality and their ability to integrate with a wide variety of industry-standard products and protocols. We released our latest version of G2, version 7.0, in March 2003. Version 7.0 included many
significant enhancements intended to bring G2 into line with current industry standards.



In addition to our continuous efforts to upgrade and enhance all of our products, which provide customers with important reasons to renew their maintenance contracts, we are pursuing a more collaborative approach with
our customers to develop and maintain applications on an ongoing basis. We anticipate that these collaborations will give us increased opportunities for incremental professional services beyond just implementation assistance, which may result in to
higher margins and more revenue per customer.



We conduct our
business in North and South America, Europe, the Middle East, Africa and the Asia-Pacific region. For each of the three- and six-month periods ended June 30, 2003, approximately 29% of our revenues were generated from license sales, 14% from
consulting and training, and 57% from customer support services. Prices for our products are generally denominated in U.S. dollars, although we do some business in local currencies. Chemical, oil and gas companies are a major market for us. Due to
the current geopolitical situation in the Middle East, we have experienced and may continue to experience a near-term reduction in the amount of business that we are able to conduct with these companies. We are affected both by the slowdown in
spending by these companies and by the logistical difficulties of negotiating business and implementing solutions.



Detailed industry knowledge and expertise are critical elements to the success of our product implementations. Therefore, we frequently work closely with
partners who are able to provide such expertise and are familiar with those markets and applications. Our partners may be value-added resellers, original equipment manufacturers, or systems integrators. These partner relationships are key to us and
account for approximately one-half of our product revenues in the six-months ended June 30, 2003.



On March 12, 2003 we acquired certain intellectual property from Key Control, Inc. This intellectual property comprises intelligent objects for embedding
in process management applications. The use of intelligent objects may significantly shorten development time and avoid implementation risk for certain applications.



9



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Critical Accounting Policies



The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial
statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, income taxes, and contingencies. We base our
estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2002. Our
critical accounting policies, as detailed in our Form 10-K for the year ended December 31, 2002, have not changed during the six-month period ended June 30, 2003.



Results of Operations



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



|                                                |  | Three monthsended June 30, |    | Six monthsended June 30,
|----------------------------------------------- |  | -------------------------- | -- | ------------------------
|                                                |  | 2003                       |    |                         
|REVENUES:                                       |  |                            |    |                         
|Product                                         |  | 29%                        |    |                         
|Services                                        |  | 71%                        |    |                         
|                                                |  |                            |    |                         
|Total revenues                                  |  | 100%                       |    |                         
|                                                |  |                            |    |                         
|                                                |  |                            |    |                         
|COST OF REVENUES:                               |  |                            |    |                         
|Product                                         |  | 7%                         |    |                         
|Services                                        |  | 23%                        |    |                         
|                                                |  |                            |    |                         
|Total cost of revenues                          |  | 30%                        |    |                         
|                                                |  |                            |    |                         
|Gross margin                                    |  | 70%                        |    |                         
|                                                |  |                            |    |                         
|                                                |  |                            |    |                         
|OPERATING EXPENSES:                             |  |                            |    |                         
|Sales and marketing                             |  | 41%                        |    |                         
|Research and development                        |  | 24%                        |    |                         
|General and administrative                      |  | 33%                        |    |                         
|Restructuring charge                            |  | 7%                         |    |                         
|                                                |  |                            |    |                         
|Total operating expenses                        |  | 105%                       |    |                         
|                                                |  |                            |    |                         
|Operating (loss) income                         |  | (35                        | )% |                         
|                                                |  |                            |    |                         
|OTHER INCOME (EXPENSES), NET                    |  | 3%                         |    |                         
|                                                |  |                            |    |                         
|Income (loss) before provision for income taxes |  | (32                        | )% |                         
|                                                |  |                            |    |                         
|PROVISION FOR INCOME TAXES                      |  | 3%                         |    |                         
|                                                |  |                            |    |                         
|Net (loss) income                               |  | (35                        | )% |                         
|                                                |  |                            |    |                         



10



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Revenues



Three and Six months Ended June 30, 2003 and 2002



Revenues



We derive revenue from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products.
Services revenues consist of fees for support and maintenance, which is generally provided on an annual contract basis, consulting services, and training courses related to our products.



Total revenues for the three-month period ended June 30, 2003 were $3,350,000, a decrease of $1,130,000, or 25%, from the
same period in 2002. This reduction was attributable to a decrease of $753,000, or 44%, in license revenue and a decrease of $377,000, or 14% in services revenue. Total revenues for the six-month period ended June 30, 2003 were $6,808,000, a
decrease of $1,990,000, or 23%, from the same period in 2002. This reduction was attributable to a decrease of $1,147,000, or 36%, in license revenue and a decrease of $843,000, or 15%, in services revenue.



Product.    Product revenues for the three-month
period ended June 30, 2003 were $958,000, a decrease of $753,000, or 44%, from the same period in 2002. This decrease was attributable to difficult economic conditions in many of the areas in which we compete, including the US, Europe, and the
Middle East. The primary reason for our decrease in revenue has been conditions in our business in chemicals, oil and gas, a major market for us, which has been severely affected by the situation in the Middle East. Product revenues for the
six-month period ended June 30, 2003 were $2,002,000, a decrease of $1,147,000, or 36%, from the same period in 2002. The reasons for the decrease in product revenues in the six-month period are the same as those pertaining to the quarter recently
completed.



Services.    Services
revenues for the three-month period ended June 30, 2003 were $2,392,000, a decrease of $377,000, or 14%, from the same period in 2002. This decrease was primarily due to a decline in customer support revenue of $199,000 or 9% and consulting revenues
of $151,000, or 26%, between the two periods. The decline in consulting revenues was an effect of the decline in license sales, which negatively affected our ability to sell consulting and training services to the purchasers of those licenses.
Delivery of consulting services also declined substantially in the Middle East due to dangerous conditions caused by the war in Iraq. Services revenues for the six-month period ended June 30, 2003 were $4,806,000, a decrease of $843,000, or 15%,
from the same period in 2002. This decrease was due to a decline in consulting and training revenues of $421,000, or 31%, between the two periods, for the same reasons discussed above. Customer support revenue decreased by $422,000, or 10%, between
the six-month period ended June 30, 2003 and the same period in 2002 due to the decreases in recent product revenues.



Cost of Revenues



Cost of revenues primarily consists of consulting labor, technical support costs, general office expenses, and the costs of material and labor involved in
producing and distributing our software. These costs for the three-month period ended June 30, 2003 were $999,000, an increase of $51,000, or 5%, from the same period in 2002. This increase was primarily due to the use of subcontractors in
delivering consulting services, increased royalty fees and amortization of intangible assets acquired in 2003. Our gross margin percentage decreased to 70% for the three-month period ended June 30, 2003 from 79% for the same period in 2002 as lower
product sales, particularly in Europe and the Middle East resulted in lower utilization of our consultants. Cost of revenues for the six-month period ended June 30, 2003 was $1,933,000, an increase of $40,000, or 2%, from the same period in 2002.
The reasons for the increase are the same as those pertaining to the quarter recently completed. Our gross margin percentage fell to 72% for the six-month period ended June 30, 2003 from 78% for the same period in 2002 primarily due to the decrease
in revenues for the period.



Product.    Product cost of revenues for the three-month period ended June 30, 2003 was $222,000, an increase of $45,000, or 25%, from the same period in 2002. This increase was primarily attributable to higher
royalty costs. Product costs for the six-month period ended June 30, 2003 were $449,000, an increase of $100,000, or 29%, from the same period in 2002. The increase between the two six-month periods was mainly attributable to an increase in royalty
costs.







11



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Services.    Services cost of revenues for the three-month period ended June
30, 2003 was $777,000, an increase of $6,000, or 1%, from the same period in 2002. Services costs for the six-month period ended June 30, 2003 were $1,484,000, a decrease of $60,000, or 4%, from the same period in 2002.



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-month period ended June 30, 2003 were $1,376,000, an increase of $189,000, or 16%, from the same period in 2002. The increase was primarily attributable to an increase in sales personnel costs and their related travel costs. Sales and
marketing expenses for the six-month period ended June 30, 2003 were $2,905,000, an increase of $477,000, or 20%, from the same period in 2002. This increase was primarily attributable to an increase in sales personnel costs and their related travel
costs. Sales and marketing expenses for the three-month period ended June 30, 2003 increased to 41% of revenues from 26% for the same period in 2002 as a result of the decrease in both product and service revenues. Sales and marketing expenses for
the six-month period ended June 30, 2003 increased to 43% of revenues from 28% for the same period in 2002. The increase in sales and marketing expenses as a percentage of revenue for both the three- and six-month periods ended June 30, 2003 as
compared to the same periods in 2002 partly reflects the addition of new sales resources, who typically take some amount of time to reach full levels of productivity.



Research and Development.    Research and development expenses consist primarily of costs of
personnel, equipment and facilities. These expenses for the three-month period ended June 30, 2003 were $816,000, a decrease of $14,000, or 2%, from the same period in 2002. This decrease was primarily attributable to reductions in subcontractor
use. Research and development expenses for the six-month period ended June 30, 2003 were $1,678,000, an increase of $144,000, or 9%, from the same period in 2002. This increase was primarily attributable to investment in a potential new product
line. Research and development expenses for the three-month period ended June 30, 2003 increased to 24% of revenues from 19% for the same period in 2002. For the six-month period ended June 30, 2003, research and development expenses as a percent of
revenues increased to 25%, from 17% for the same period in 2002.



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-month period ended June 30, 2003 were $1,081,000, an increase of $130,000, or 14%, from the same period in 2002. This increase was mainly attributable to increases in accounting and legal fees offset by a decrease in
other professional services. General and administrative expenses for the six-month periods ended June 30, 2003 and 2002 were each $1,796,000.



Restructuring Charges.    In June 2003, the Companys board of directors approved a workforce reduction plan. Given the
uncertain economic conditions, we have decided to take certain actions to reduce our expenses to a level that is commensurate with current levels of revenue. As a result of implementation of this plan, the Company recorded a pre-tax restructuring
charge of $250,000 in the second quarter of 2003. The charge is based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement
benefit plans in Europe and related legal costs. No costs were incurred prior to June 30, 2003, however the Company expects to complete the plan by March 31, 2004. Some of the impact of the actions will be realized immediately, and we expect that
additional savings will be realized by December 31, 2003.







12



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Other income, net.    Other income, net consists primarily of
interest income and expense, realized gains or losses on foreign exchange transactions, and translation adjustments charged to income. Other income, net for the three-month period ended June 30, 2003 was $86,000, compared to income of $37,000 for
the same period in 2002. The increase is primarily due to foreign exchange rate gains due to the strength of the Euro. Other income, net for the six-month period ended June 30, 2003 was $109,000, compared to income of $19,000 for the same period in
2002. The increase is primarily due to foreign exchange rate gains due to the strength of the Euro.



Income Taxes.     Our provision for income taxes primarily pertains to foreign withholding tax and income taxes
in foreign jurisdictions where our wholly-owned subsidiaries have taxable income but do not have operating loss carry forwards. Our effective tax rate for the six-month period ended June 30, 2003 was 10.9%. This is lower than the statutory tax rate
because our domestic operations have recorded losses for the six-months ended June 30, 2003 and we have no federal or state tax liabilities in the United States.



LIQUIDITY AND CAPITAL RESOURCES



Our June 30, 2003 cash and cash equivalents amounted to $2,969,000, a decrease of $915,000 from $3,884,000 at December 31, 2002. Net cash used in
operating activities for the six-month period ended June 30, 2003 was $558,000. Specifically, we had a net loss of $1,824,000, net of non-cash expenses of 421,000 (depreciation and amortization, loss on disposal of equipment, issuance of treasury
shares, and provision for bad debt), $1,634,000 in cash received from accounts receivable, $250,000 increase in restructuring and a $10,000 decrease in accounts payable offset by a decrease of $528,000 in accrued expenses and $264,000 in deferred
revenue and an increase in other assets of $257,000.



Cash used
in investing activities for the six-month period ended June 30, 2003 was $529,000, which consisted of $279,000 in purchases of property and equipment and $250,000 used to purchase an intangible asset.



Cash provided by financing activities for the six-month period ended June 30,
2003 was $68,000, consisting of $54,000 in additional capital lease obligations, and $49,000 in proceeds from exercise of stock options and issuance of common stock under stock plans, offset by $35,000 in payments under capital leases.



13



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On March 28, 2001, we entered into an accounts receivable financing agreement with Silicon Valley Bank.
The financing agreement provides us with the ability to borrow up to 80% of our qualified and eligible gross domestic accounts receivable up to a maximum of $2.5 million. Borrowings under this agreement will be at an interest rate of 2% per month of
the average gross daily purchase account balance, plus an administration fee of 1% of gross purchased account receivables. On August 16, 2001, we renegotiated the terms of the financing agreement, and signed an accounts receivable purchase agreement
that does not include restrictive financial covenants. The total available borrowings, interest rate and administrative fee under the renegotiated facility remain unchanged. At June 30, 2003 we had no borrowings outstanding under this facility.
Amounts borrowed under this facility are secured by a pledge of substantially all of our corporate assets. The facility may be terminated by either party at any time. As of June 30, 2003, the amount of eligible borrowings under this facility was
approximately $481,000.



We currently finance our operations,
along with capital expenditures, primarily through cash flows from operations and our current cash. Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We also have capital leases for certain
computer and communications equipment.



Our liquidity is
affected by many factors, some based on the normal operations of our business and others related to the uncertainties of our industry and global economies. We expect our operating expenses to decline as a result of the restructuring currently in
progress. Although our future cash flows will fluctuate based on the factors set forth below in Factors that May Affect Future Results, we believe that our current cash and cash equivalents and cash flows from future operations will be
sufficient to meet our operating, investing and financing requirements for at least the next twelve months.



Commitments and Contingencies



Leases



The Company leases its facilities and
certain equipment under operating and capital leases. The future minimum annual payments under these leases at June 30, 2003 are as follows:



|                                              |  | Amounts(In thousands)
|--------------------------------------------- |  | ---------------------
|For the period ended December 31              |  | OperatingLeases      
|2003                                          |  | $                    
|2004                                          |  |                      
|2005                                          |  |                      
|2006                                          |  |                      
|                                              |  |                      
|Total minimum lease payments                  |  | $                    
|                                              |  |                      
|Less: Amount representing interest            |  |                      
|                                              |  |                      
|Present value of minimum lease payments       |  |                      
|Less: Current portion                         |  |                      
|                                              |  |                      
|Long-term portion of capital lease obligation |  |                      
|                                              |  |                      
|                                              |  |                      
|Other Contractual Obligations                 |  |                      







14



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Stock Repurchase Program



In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market.
As of June 30, 2003, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2003 or 2002. In 2003 and 2002, respectively, we reissued 42,706 and 35,957 shares of common stock to non-employee directors
and a consultant. As of June 30, 2003, 422,637 shares remained in treasury at a cost of $1,576,000.



Related party transaction



On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving an employee who continues to work for us. The agreement calls for the
payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. During the three
month period ended June 30, 2003, we paid Integration Objects $85,000 for a total of $116,000 for the 6 month period ended June 30, 2003.



Factors That May Affect Future Results



The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by
forward-looking statements made in this Form 10-Q or presented elsewhere by our management from time to time.



We have a history of operating losses, and we may not return to profitability.



We have incurred operating losses for four of the five years in the period ended December 31, 2002. In August 2001, we
announced a strategic restructuring of our company that included a 40% reduction in workforce, a realignment of our software and services product lines and a renewed focus on our existing customers. With the restructuring, we achieved profitability
for each of the quarters in 2002. However, due to continued declines in our product and service revenues, which we were not able to offset by additional reductions in expenses, we incurred losses for the first two quarters of 2003. Our ability to
return to profitability will depend on our ability to control our expenses, achieve cost reductions and derive additional revenue from new and existing customers. However, there can be no assurance that we will be able to return to profitability in
the future.



Competition in the market for expert operations
management systems is intensifying and may reduce our revenues.



Substantially all of our revenues are derived from the licensing and support of software platforms and products for expert operations management. Although organizations such as Objective Systems Integrators, Inc., Micromuse and Systems
Management Arts (SMARTS) have begun to deploy, or have announced plans to deploy, such systems, our 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 expert operations management systems successfully, nor that such systems will gain widespread acceptance. In addition, the timing of the implementation of expert operations management systems by
organizations may be affected by economic factors, government regulations, and other factors. Delays in the introduction of expert operations management systems or the failure of these systems to gain widespread market acceptance would materially
and adversely affect our business, results of operations, or financial condition. In addition, we believe that end-users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than
general software tools to develop application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are also increasingly reliant on value-added resellers and systems integrators to satisfy market
requirements. The modified sales approach may also lengthen our average sales cycle. Our failure to respond appropriately to shifts in market demand could have a material adverse effect on our business, results of operations, or financial condition.



We rely heavily on indirect distribution channels and
strategic partner relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.



We sell our products in part through value-added resellers, systems integrators, original equipment manufacturers and distributors, which are not under
our control. Product sales through these channels represented 52% and 39% of our product revenues in the six-month periods ending June 30, 2003 and 2002 respectively. We rely heavily on our indirect sales partners for sales of our expert operations
management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing
successful G2-based applications could have a material adverse effect on our business, results of operations, or financial condition. There can be no assurance that we will be able to attract or retain additional qualified third-party resellers, or
that third-party resellers will be able to effectively sell and implement our products. In addition, we rely on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service and support could
adversely affect our business, results of operations, or financial condition.





15



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We depend heavily on our sales and marketing force.



Our future success in the expert operations management marketplace will
depend, in part, upon the productivity of our sales and marketing personnel and our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel. There can be no assurance that our investment in sales and
marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better-funded sales and marketing
operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, operating results and financial condition.



Our quarterly operating results may vary, leading to fluctuations in
trading prices for our common stock and possible liquidity problems.



We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a
quarterly basis in the future. Our sales cycle typically ranges from six to twelve months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our
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, we ship software products within a short period after receipt of an order and typically do
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 executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these orders is delayed, it could result in a
substantial reduction in revenues for that quarter. Our 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 our net income and cash
flows, which may impact our ability to continue as an independent concern.



Our common stock has been delisted from the Nasdaq National Market. As a result of the delisting, our stockholders may face an illiquid market for the shares of our stock that they own.



Our common stock was delisted from the Nasdaq National
Market on August 20, 2001 because we failed to meet the listing standards required by Nasdaq. The delisting may negatively impact the liquidity of our common stock, not only in the number of shares that can be bought or sold, but also through delays
in the timing of transactions and the reductions in potential security analyst and media coverage. This may reduce the demand for our common stock and its trading price. The delisting may also impair our ability to raise additional working capital.



Sales of our products are highly dependent on our
customers capital expenditure budgets. If an economic downturn causes our customers to reduce their capital expenditures, our revenues may be further adversely affected.



Because capital expenditures are often viewed as discretionary by organizations, sales of our products for capital budget
projects are subject to general economic conditions. Future recessionary conditions in the industries that use our products may adversely affect our business, results of operations, or financial condition.



We rely heavily on revenues from our G2 and G2-based products. If demand
for the G2 product declines, our revenues may be adversely affected.



Substantially all of our license revenues are derived from G2, a customizable object-oriented development and deployment platform for building expert operations management systems, and from software application
products based on G2 and other core technologies. Accordingly, our business and financial results are substantially dependent upon the continued customer acceptance and deployment of G2 and our other products. The timing of major G2 releases may
affect the timing of purchases of our products. We have introduced several G2-based products for building applications and are developing others. We believe that market acceptance of these products will be important to our future growth. There can
be no assurance that such products will achieve market acceptance or that new products will be successfully developed.



In addition, we rely on many of our distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial
results are also linked to the continued successful product development by our partners and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a result



16



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of competitive products, price competition, the lack of success of our partners, technological change, the shift in
customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of operations, or financial condition.



Our business may be adversely affected if we fail to develop new products and respond to changes in technology.



The market for our products is characterized by rapid
technological change, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements. Our future success will depend in part upon our ability to enhance our 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. We have from time to time experienced delays in introducing new products and product
enhancements. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and product enhancements. There also can be no assurance that
we will successfully complete the development of new or enhanced products, that we will successfully manage the transition to future versions of G2, or to successor technology, or that our future products will achieve market acceptance. In addition,
the introduction of products embodying new technologies and the emergence of new industry standards could render our 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 our 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 our existing products.



Our
business may suffer if we fail to address the challenges associated with international operations.



Our international revenues represented 54% and 52% of our total revenues for the six-month periods ending June 30, 2003 and 2002, respectively. We
categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international portion of our 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 including the euro, fluctuating
import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, or financial condition.



Our business may suffer if we fail to remain competitive
with other companies offering similar products and services.



A number of companies offer products that perform certain functions of G2 for specific applications. In all of our markets, there is competition from point solutions, real-time and expert system products, and internally
developed software. There are commercially available software development tools that software application developers or potential customers could use to build software that has functionality similar to our products.



Certain companies, such as Objective Systems Integrators, Inc., Micromuse,
RiverSoft and Systems Management Arts (SMARTS), sell point solutions that compete with our expert operations management products with respect to specific applications or uses. Several companies, including Aspen Technologies, Ilog S.A.,
Pavilion and System Management Arts, offer expert operations management products with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. Many of these products often require
extensive programming with languages such as C or C++ for complete implementation. Although we believe 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 we do and might introduce new or improved products to compete with G2, possibly at lower prices.



Our software is also 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 our software.



Many of our
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 our products. There is no assurance that we can successfully persuade development personnel within these customers organizations to use G2-based products that can cost
effectively compete with their internally developed products. Thus there could be a reduction in the need for our products and services that may limit our future opportunities.



We believe that continued investment in research and development and sales and marketing will be required to maintain our
competitive position. There can be no assurance that competitors will not develop products or provide services that are superior to our products or services or achieve greater market acceptance. Competitive pressures faced by us could force us to
reduce our prices, which could result in reduced profitability. There can be no assurance that we will be able to compete



17



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successfully against current and future sources of competition or that such competition will not have a material adverse
effect on our business, results of operations, or financial condition.



Our software is complex and may contain undetected errors. Such errors could cause costly delays in product introduction or require costly software design modifications.



Complex software products such as those offered by us may contain unintended errors or failures commonly referred to as
bugs. There can be no assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have 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 our business, results of operations, or financial condition.



Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or
if third parties successfully assert infringement claims against us.



Our success is heavily dependent upon our proprietary technology. We rely upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and
technology. We enter into confidentiality and/or license agreements with our employees, third-party resellers, and end-users and limit access to and distribution of our software, documentation, and other proprietary information. In addition, we have
placed technical inhibitors in our 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 our products are
distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be adequate to prevent misappropriation of our 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.



On August 2, 2001, we received a letter from a third party alleging that we are infringing one or more of their patents
relating to neural networks expert systems and the control of processes. While we believe that these allegations are without merit, there can be no assurance that the third party will not file formal legal action relating to its claims or, if formal
legal action is filed, that our defense against those claims will be successful.



Recent Accounting Pronouncements



In May 2003,
the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS No. 150). This statement affects the classification, measurement
and disclosure requirements of the following three types of freestanding financial instruments: 1) mandatorily redeemable shares, which the issuing company is obligated to buy back with cash or other assets; 2) instruments that do or may require the
issuer to buy back some of its shares in exchange for cash or other assets, which includes put options and forward purchase contracts; and 3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or
predominantly to a variable such as a market index, or varies inversely with the value of the issuers shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim
periods beginning after June 15, 2003. The Company does not expect FAS No. 150 to have a significant impact on its financial statements.



18



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ITEM 3.    Qualitative and Quantitative Disclosures About Market Risk



Investment Portfolio



We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand
deposit accounts we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At June 30, 2003, substantially all of
our funds were in demand deposit accounts.



Impact of Foreign Currency Rate
Changes



Our contracts with customers are generally
denominated in U.S. dollars or Euros and, in general, exchange rate fluctuations have not had a material impact on our consolidated financial position, results of operations or cash flows. We do not use foreign exchange forward contracts to hedge
our foreign currency denominated receivables. There can be no assurance that changes in foreign currency rates, relative to the U.S. dollar, will not materially affect our consolidated results in the future.



ITEM 4.    Controls and Procedures.



Our management, with the participation of our chief executive officer and
principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of June 30, 2003. In designing and evaluating our disclosure controls and
procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our chief executive officer and principal financial officer concluded that, as of June 30, 2003, our disclosure controls and procedures were (1) designed to
ensure that material information relating to us, including our consolidated subsidiaries, is made known to our chief executive officer and principal financial officer by others within those entities, particularly during the period in which this
report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SECs rules and forms.



Except as set forth below, no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June 30, 2003 that has materially affected,
or is reasonably likely to materially affect, our internal control over financial reporting.



During, and shortly following, the fiscal quarter ended June 30, 2003, we experienced turnover in our accounting and finance organization. In particular, our corporate controller left the company and our European
controller was on a personal leave of absence beginning in June 2003. Furthermore, our former chief financial officer left the company in early August 2003.



In connection with their interim review procedures for the quarter ended June 30, 2003, our auditors, PricewaterhouseCoopers LLP, communicated to
management and the audit committee of the board of directors that the loss, or temporary absence of, these personnel resulted in certain conditions which, when considered collectively, constitute a material weakness in our internal controls. Such
conditions include: insufficient resources to perform an appropriate review and supervision of the preparation of accounting records related to the our foreign subsidiaries, insufficient resources to accurately prepare consolidated financial
statements from detailed accounting records, and insufficient resources to oversee the preparation of the consolidated financial statements. We have performed additional procedures to evaluate the extent to which these internal control deficiencies
could have led to material misstatements in our consolidated financial statements. We do not believe that the insufficient resources and consequent control weaknesses noted above led to any material misstatements in the consolidated financial
statements included in this report.



We are in the process of
implementing actions as of the date of this Form 10-Q to address these issues and are evaluating other corrective actions, including the following:



| |  |  | We have engaged David Ramsdell, on a part-time basis, to perform the chief financial officer function. Mr Ramsdell had served us in a similar capacity from late 1998 to early 2000.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have initiated a search for a new permanent chief financial officer.
| | - |  | -----------------------------------------------------------------------



| |  |  | We are seeking to supplement our accounting and financial reporting resources.
| | - |  | ------------------------------------------------------------------------------



| |  |  | We are evaluating our procedures for preparing our consolidation for financial reporting purposes.
| | - |  | --------------------------------------------------------------------------------------------------



19



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PART II.  OTHER INFORMATION



Item 5.    Submission of Matters to a Vote of Security Holders



(a)    Our 2003 annual meeting of stockholders was held
on May 12, 2003.



(b)    At our 2003 annual
meeting of stockholders, our stockholders elected John A. Shane and Thomas E. Swithenbank to serve as directors of the Company until our 2006 annual meeting of stockholders and until their successors are duly elected and qualified. In addition to
the directors listed above who were elected at the 2003 annual meeting of stockholders, the terms of the following directors continued after the 2003 annual meeting: Frank Cianciotta, Robert A. Degan, Barry R. Gorsun and Lowell B. Hawkinson.



(c)    The matters acted upon at the 2003
annual meeting of stockholders, and the voting tabulation for each such matter, is as follows:



Proposal 1:  To elect two Class I directors to the board of directors for the ensuing three years:



|                      |  | Number of Votes
|--------------------- |  | ---------------
|Nominees              |  | For            
|John A. Shane         |  | 5,223,591      
|Thomas E. Swithenbank |  | 5,223,691      



Each
of the above named individuals was elected as a Class I director.





Proposal 2:  To ratify the appointment of PricewaterhouseCoopers LLP as our independent accountants for the fiscal year ending December 31,
2003:



|Number of Votes
|---------------
|For            
|5,626,527      



The
proposal was approved.



ITEM 6.    Exhibits



(a)  Exhibits.    The following exhibit is filed as part of this Report on Form 10-Q:



|Exhibit Number |  | Description                                                                                                                                                                                      
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|               | 
|31.1           |  | Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
|               | 
|31.2           |  | Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
|               | 
|32.1           |  | Certifications of Chief Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.              
|               |  |                                                                                                                                                                                                  



20



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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)



Dated August 14, 2003

/s/  MICHAEL A. MORNEAU

Michael A. Morneau

Corporate Controller

(Principal Accounting Officer)





21



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EXHIBIT INDEX

|ExhibitNumber |  | Description                                                                                                                                                                                      
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|              | 
|31.1          |  | Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
|              | 
|31.2          |  | Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
|              | 
|32.1          |  | Certifications of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.