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

(Mark one)

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

                   FOR THREE MONTHS ENDED SEPTEMBER 30, 1998
                                        

                                       OR

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


                        COMMISSION FILE NUMBER:  0-27696

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

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

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

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



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

                          Yes [X]                  No [_]


     As of November 2, 1998 there were 6,464,770 shares of the Registrant's
Common Stock outstanding.
<PAGE>
 
                               GENSYM CORPORATION
                                Form 10-Q INDEX

                         PART I. FINANCIAL INFORMATION

<TABLE>
<CAPTION>
                                                                        PAGE NO.
                                                                        --------
<S>                                                                    <C>
Item 1.    Condensed Consolidated Financial Statements:
 
           Condensed Consolidated Balance Sheets
           September 30, 1998 and December 31, 1997                       3
 
           Condensed Consolidated Statements of Operations
           Three and nine months ended September 30, 1998 and 1997        4
 
           Condensed Consolidated Statements of Cash Flows
           Nine months ended September 30, 1998 and 1997                  5
 
           Notes to Condensed Consolidated Financial Statements         6-7
 
Item 2.    Management's Discussion and Analysis of
           Financial Condition and Results of Operations               8-20
 
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    20
 
<CAPTION>
                           PART II. OTHER INFORMATION
<S>                                                                    <C>
Item 1.    Legal Proceedings                                             21
 
Item 2.    Changes in Securities and Use of Proceeds                     21
 
Item 3.    Defaults Upon Senior Securities                               21
 
Item 4.    Submission of Matters to a Vote of Security Holders           21
 
Item 5.    Other Information                                             21
 
Item 6.    Exhibits and Reports on Form 8-K                              21
 
           Signatures                                                    22
 
</TABLE>

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


                      GENSYM CORPORATION AND SUBSIDIARIES
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                  (Unaudited)
<TABLE>
<CAPTION>
 
(in thousands)                             SEPTEMBER 30,           DECEMBER 31,
                                               1998                    1997
                                               ----                    ----
<S>                                       <C>                     <C>
ASSETS                                                        
                                                              
Current Assets:                                               
     Cash and cash equivalents              $13,095                $10,958
     Short-term investments                   3,227                  4,843
     Accounts receivable, net                 7,970                  8,311
     Prepaid expenses                         1,587                  1,565
     Deferred income taxes                    1,160                  1,160
                                            -------                -------
       Total current assets                  27,039                 26,837
                                            -------                -------
                                                              
                                                              
Property and Equipment, net                   2,225                  2,384
                                                              
Long-term investments                             0                  1,041
Long-term deferred income taxes               1,000                  1,000
Deposits and other assets                       199                    255
                                            -------                -------
                                            $30,463                $31,517
                                            =======                ======= 
                                                              
                                                              
LIABILITIES AND STOCKHOLDERS' EQUITY                          
                                                              
Current Liabilities:                                          
     Accounts payable                       $   937                $   914
     Accrued expenses                         4,272                  4,976
     Deferred revenue                         6,221                  5,799
                                            -------                -------
       Total current liabilities             11,430                 11,689
                                            -------                -------
                                                              
Stockholders' Equity:                                         
     Common stock                                65                     64
     Capital in excess of par value          20,188                 19,941
     Treasury stock                            (731)                     0
     Retained earnings                          107                    387
     Cumulative translation adjustment         (596)                  (564)
                                            -------                -------
       Total stockholders' equity            19,033                 19,828
                                            -------                -------
                                            $30,463                $31,517
                                            =======                ======= 
</TABLE> 
  The accompanying notes are an integral part of these condensed consolidated
                             financial statements.

                                       3
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (UNAUDITED)
 
<TABLE>
<CAPTION>
(in thousands except per share amounts)
                                                    THREE MONTHS ENDED             NINE MONTHS ENDED
                                                       SEPTEMBER 30,                 SEPTEMBER 30, 
                                                     1998          1997           1998         1997
                                                     ----          ----           ----         ----
<S>                                               <C>          <C>            <C>          <C> 
REVENUES:                                                                                   
  Product                                          $4,258       $ 3,889        $13,402      $13,158
  Service                                           4,489         4,202         13,453       12,839
                                                   ------       -------        -------      -------
       Total revenues                               8,747         8,091         26,855       25,997
                                                   ------       -------        -------      -------
COST OF REVENUES                                    2,193         2,388          6,568        7,128
                                                   ------       -------        -------      -------
       Gross profit                                 6,554         5,703         20,287       18,869
                                                   ------       -------        -------      -------
OPERATING EXPENSES:                                                                         
  Sales and marketing                               4,563         4,471         13,512       14,219
  Research and development                          1,516         1,654          4,506        5,423
  General and administrative                          934         1,150          3,011        3,444
  Restructuring charge (credit)                         0          (485)             0        1,557
                                                   ------       -------        -------      -------
                                                    7,013         6,790         21,029       24,643
                                                   ------       -------        -------      -------
                                                                                            
       Operating Loss                                (459)       (1,087)          (742)      (5,774)
                                                                                            
OTHER INCOME, NET                                     179           507            512          641
                                                   ------       -------        -------      -------
                                                                                            
       Loss before provision for                                                            
         income taxes                                (280)         (580)          (230)      (5,133)
                                                                                            
PROVISION FOR INCOME TAXES                              0             0             50           40
                                                   ------       -------        -------      -------
       Net loss                                    $ (280)      $  (580)       $  (280)     $(5,173)
                                                   ======       =======        =======      =======
       Basic and diluted net loss                                                           
         per share                                 $(0.04)      $ (0.09)       $ (0.04)     $ (0.82)
                                                   ======       =======        =======      =======
       Weighted average common shares                                                       
         outstanding                                6,377         6,338          6,413        6,287
                                                   ======       =======        =======      =======

</TABLE> 
The accompanying notes are an integral part of these condensed consolidated
                             financial statements.

                                       4
<PAGE>
 
                      GENSYM CORPORATION AND SUBSIDIARIES
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (UNAUDITED)
 
<TABLE>
<CAPTION>
 
(in thousands)                                                                               
                                                                                            NINE MONTHS ENDED
                                                                                               SEPTEMBER 30,
                                                                                        1998                   1997
                                                                                        ----                   ----   
<S>                                                                                <C>                    <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
     Net loss                                                                        $  (280)               $(5,173)
     Adjustments to reconcile net loss to net
       cash provided by (used in) operating
       activities:
       Depreciation                                                                      926                    887
       Restructuring charge                                                             (144)                 1,525
       Changes in assets and liabilities:
         Accounts receivable                                                             348                  1,616
         Prepaid expenses                                                                (54)                  (313)
         Accounts payable                                                                 21                   (196)
         Accrued expenses                                                               (592)                  (472)
         Deferred revenue                                                                426                   (358)
                                                                              --------------         --------------
           Net cash provided by (used in) operating activities                           651                 (2,484)
                                                                              --------------         --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
     Sale of short-term investments                                                    1,616                  2,453
     Sales (purchases) of long-term investments                                        1,041                   (303)
     Purchases of property and equipment                                                (767)                (1,162)
     Increase (decrease) in other assets                                                  84                    (77)
                                                                              --------------         --------------
           Net cash provided by investing activities                                   1,974                    911
                                                                              --------------         --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
     Proceeds                                                                            248                    848
     from exercise of stock under stock plans
     Purchase                                                                           (731)                     -
     of treasury stock
                                                                              --------------         --------------
           Net cash provided by (used in) financing activities                          (483)                   848
                                                                              --------------         --------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH                                                   (5)                  (289)
                                                                              --------------         --------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                   2,137                 (1,014)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                        10,958                 11,679
                                                                              --------------         --------------
CASH AND CASH EQUIVALENTS, END OF PERIOD                                             $13,095                $10,665
                                                                              ==============         ==============
</TABLE> 
The accompanying notes are an integral part of these condensed consolidated
                             financial statements.

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

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

2.  Basis of Presentation

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

3.  Cash Equivalents and Investments

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

4.  Recently Issued Accounting Pronouncements

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

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

                                       6
<PAGE>
 
5.   Comprehensive Income

The Company adopted Statement of Financial Accounting Standards No. 130,
Reporting Comprehensive Income ("SFAS No. 130"), effective January 1, 1998.
SFAS No. 130 requires that items defined as other comprehensive income, such as
foreign currency translation adjustments, be separately classified in the
financial statements and that the accumulated balance of other comprehensive
income be reported separately from retained earnings and additional paid-in
capital in the equity section of the balance sheet.  The components of
comprehensive income for the three and nine months ended September 30, 1998 and
1997 are as follows (in thousands):
<TABLE> 
<CAPTION> 
                                                             THREE MONTHS ENDED       NINE MONTHS ENDED
                                                                SEPTEMBER 30,            SEPTEMBER 30,
                                                              1998        1997        1998         1997
                                                            --------    -------     --------     --------
<S>                                                         <C>         <C>         <C>          <C> 
Comprehensive income (loss):
    Net loss                                                $   (280)   $  (580)    $   (280)    $ (5,173)
    Other comprehensive income (loss):
      Foreign currency adjustment                                 77        (68)         (32)        (318)
                                                            --------    -------     --------     --------
          Comprehensive loss                                $   (203)   $  (648)    $   (312)    $ (5,491)
                                                            ========    =======     ========     ========
</TABLE> 

6.    Earnings Per Share

In accordance with SFAS No. 128, Earnings per Share, basic net loss per share
was computed by dividing net loss by the weighted average number of common
shares outstanding during the three and nine-month periods ended September 30,
1998 and 1997. Diluted net loss per share for the three and nine months ended
September 30, 1998 and 1997 was computed using the weighted average number of
common shares outstanding. As of September 30, 1998 and 1997, 38,351 and 84,061,
stock options, respectively, were not included in diluted weighted average
shares outstanding as the effect would have been antidilutive.

7.    Stockholders' Equity

On July 1, 1998, the  Board of Directors approved a plan for the Company to
repurchase up to 650,000 shares of the Company's common stock.  Common stock
share repurchases are funded using available cash.  As of September 30, 1998,
the Company had repurchased 194,200 shares at a cost of $731,000.

 

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

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

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

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

                                       8
<PAGE>
 
RESULTS OF OPERATIONS

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



<TABLE>
<CAPTION>
                                                           THREE MONTHS ENDED                     NINE MONTHS ENDED
                                                              SEPTEMBER 30,                         SEPTEMBER 30,
                                                        1998                1997                1998                1997
                                                        ----                ----                ----                ----
<S>                                                  <C>                 <C>                 <C>                 <C>
REVENUES:                                          
   Product                                              48.7%               48.1%               49.9%               50.6%
   Service                                              51.3%               51.9%               50.1%               49.4%
                                                   -----------         -----------         -----------         -----------
        Total revenues                                 100.0%              100.0%              100.0%              100.0%
                                                   -----------         -----------         -----------         -----------
COST OF REVENUES                                        25.1%               29.5%               24.5%               27.4%
                                                   -----------         -----------         -----------         -----------
        Gross profit                                    74.9%               70.5%               75.5%               72.6%
                                                   -----------         -----------         -----------         -----------
OPERATING EXPENSES:                                
   Sales and marketing                                  52.2%               55.3%               50.3%               54.7%
   Research and development                             17.3%               20.4%               16.8%               20.9%
   General and administrative                           10.7%               14.2%               11.2%               13.2%
   Restructuring charge (credit)                           0%               (6.0%)               0.0%                6.0%
                                                   -----------         -----------         -----------         -----------
                                                        80.2%               83.9%               78.3%               94.8%
                                                   -----------         -----------         -----------         -----------
        Operating loss                                  (5.3%)             (13.4%)              (2.8%)             (22.2%)
                                                   -----------         -----------         -----------         -----------
                                                   
OTHER INCOME, NET                                        2.0%                6.2%                1.9%                2.5%
                                                   -----------         -----------         -----------         -----------
        Loss before provision for income taxes          (3.3%)              (7.2%)              (0.9%)             (19.7%)
                                                   
PROVISION FOR INCOME TAXES                               0.0%                0.0%                0.2%                0.2%
                                                   -----------         -----------         -----------         -----------
        Net loss                                        (3.3%)              (7.2%)              (1.1%)             (19.9%)
                                                   ===========         ===========         ===========         ===========
</TABLE>

                                       9
<PAGE>
 
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997

Revenues

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

  Total revenues for the three and nine months ended September 30, 1998 were
$8.7 million and $26.9 million, respectively, an increase of 8.1% and 3.3% from
$8.1 million and $26.0 million in the comparable periods of fiscal 1997.  For
the three-month period ended September 30, 1998 the increase in total revenues
was attributable to increased sales of product licenses and consulting services,
primarily in the United States.  For the nine-month period ended September 30,
1998, the increase in total revenues was primarily attributable to an increase
in service revenues and, to a lesser extent, to an increase in product licenses.
For the three and nine months ended September 30, 1998 international revenues
accounted for 38.6% and 43.8% of total revenues, respectively, compared to 38.6%
and 43.9% of total revenues in the comparable periods of fiscal 1997.

     Product.  Product revenues for the three and nine months ended September
30, 1998 were $4.3 million and $13.4 million, respectively, an increase of 9.5%
and 1.9% from $3.9 million and $13.2 million in the comparable periods of fiscal
1997. Product revenues for the three months ended September 30, 1998, increased
principally due to the Company recording $925,000 in revenue as part of an OEM
license arrangement.  Product revenues for the nine month period declined as a 
result of a business slowdown in the European and Asian markets which was, in 
part, offset by growth in the domestic revenues.

  Service. Service revenues for the three and nine months ended September 30,
1998 were $4.5 million and $13.5 million, respectively, an increase of 6.8% and
4.8% from $4.2 million and $12.8 million in the comparable periods of fiscal 
1997. The increase in service revenues for both the three and nine-month periods
ended September 30, 1998, was primarily due to an increase in application
consulting revenues and, to a lesser extent, increased maintenance fees derived
from an increased customer base, partially offset by a decrease in educational
services.


Cost of Revenues

  Cost of revenues primarily consists of consulting labor, technical support
costs and the costs of material and labor involved in producing and distributing
the Company's software.  These costs for the three and nine months ended
September 30, 1998 were $2.2 million and $6.6 million, respectively, a decrease
of 8.2% and 7.9% from $2.4 million and $7.1 million in the comparable periods of
fiscal 1997.  Gross profit on revenues for the three and nine months ended
September 30, 1998 was 75% and 76%, respectively, an improvement from 70% and
73% in the comparable periods of fiscal 1997.  The increase in gross profit for
the three and nine-month periods ended September 30, 1998, resulted primarily
from improved utilization of consulting personnel as well as lower product
distribution costs.


Operating Expenses

  Sales and Marketing.  Sales and marketing expenses consist primarily of costs
associated with personnel involved in the sales and marketing process, sales
commissions, sales facilities, travel and lodging, trade shows and seminars,
advertising and promotional materials. These expenses for the three and nine
months ended September 30, 1998 were $4.6 million and $13.5 million,
respectively, an increase of 2.1% and a decrease of 5.0% from $4.5 million and
$14.2 million in the comparable periods of fiscal 1997.  As a percentage of
revenues, sales and marketing expenses were 52.2% and 50.3%, respectively, for
the three and nine months ended September 30, 1998 compared to 55.3% and 54.7%
for the comparable periods of fiscal 1997.  The decrease for the nine months

                                       10
<PAGE>
 
ended September 30, 1998 was primarily due to lower facility and leased
equipment costs due to the consolidation of field sales offices and other
actions taken in connection with the Company's restructuring implemented in the
comparable period of fiscal 1997.

  Research and Development.  Research and development expenses consist primarily
of costs of personnel, equipment, and facilities. These expenses for the three
and nine months ended September 30, 1998 were $1.5 million and $4.5 million,
respectively, a decrease of 8.4% and 16.9% from $1.7 million and $5.4 million in
the comparable periods of fiscal 1997.  As a percentage of revenues, research
and development expenses were 17.3% and 16.8%, respectively, for the three and
nine months ended September 30, 1998 as compared to 20.4% and 20.9% for the
comparable periods of fiscal 1997. The decrease was primarily due to a reduction
in personnel, the consolidation of headquarter facilities, and other actions
taken in connection with the Company's restructuring implemented in the nine
month period ended September 30, 1997. 

  General and Administrative.  General and administrative expenses consist
primarily of personnel costs for finance, administration, operations, and
general management, as well as legal and accounting expenses. These expenses for
the three and nine months ended September 30, 1998 were $900,000 and 
$3.0 million, respectively, a decrease of 18.8% and 12.6% from $1.2 million and
$3.4 million in the comparable periods of fiscal 1997. As a percentage of
revenues, general and administrative expenses were 10.7% and 11.2%,
respectively, for the three and nine months ended September 30, 1998 as compared
to 14.2% and 13.2% for the comparable periods of fiscal 1997. The decrease was
primarily due to a reduction in personnel, the consolidation of headquarter
facilities, and other actions taken in connection with the Company's
restructuring implemented in the nine month period ended September 30, 1997.

Other Income

  Other income consists primarily of interest income partially offset by foreign
exchange transaction gains and losses.  Other income for the three and nine
months ended September 30, 1998 was $179,000 and $512,000, respectively, as
compared to $507,000 and $642,000 in the comparable periods of fiscal 1997. The
decrease in the three and nine-month periods ended September 30, 1998 was
primarily attributable to the Company's recovery of its 50% share of a joint
venture investment during the same period in 1997, partially offset by an
increase in interest income due to higher cash balances and a decrease in
foreign exchange transaction losses.

Income Taxes

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

                                       11
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

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

  The Company's operating activities generated of $651,000 and used $2.5 million
during the first nine months of 1998 and 1997, respectively. Cash generated in
operations in the first nine months of 1998 was primarily due to a decrease in
accounts receivable and increases in deferred revenue and accounts payable,
partially offset by a decrease in accrued expenses and an increase in prepaid
expenses. Cash used in operations in the first nine months of 1997 was primarily
due to the net loss for that period and decreases in accounts payable, accrued
expenses and deferred revenue, partially offset by the restructuring charge and
a decrease in accounts receivable. During the nine-month period ended September
30, 1998 the Company's net accounts receivable balance decreased to $8.0 million
from $8.3 million. Days sales outstanding was 79 days at September 30, 1998
compared to 73 days at June 30, 1998 and 79 days at both March 31, 1998 and
December 31, 1997.

  Investing activities provided $2.0 million and $911,000 during the nine-month
period ended September 30, 1998 and 1997, respectively. The principal proceeds
in the nine-month period ending September 30, 1998 were from the sale of $1.6
million in short-term investments and $1.0 million in long-term investments,
partially offset by the purchase of $767,000 in property and equipment,
including a sales force automation software system. During the nine-month period
ended September 30, 1997, the sale of short-term investments provided 
$2.5 million, which was offset primarily by the purchase of $1.2 million in
property and equipment, principally computer equipment and software, and by the
purchase of $303,000 in long-term investments. The Company expects that its
requirements for computers, office facilities, and office equipment will
fluctuate as staffing requirements dictate and that such equipment and
facilities will be available when needed.

  Financing activities utilized $483,000 and provided $848,000 during the nine-
month period ended September 30, 1998 and 1997, respectively. The principal use
in the nine-month period ending September 30, 1998 was the purchase of $731,000
of treasury stock, partially offset by proceeds of $248,000 from the exercise of
stock options under stock option plans. During the nine-month period ended
September 30, 1997, $848,000 was generated from the exercise of stock options
under stock option plans. In the third quarter of 1998, the Company began a
program to repurchase up to 650,000 shares of its common stock on the open
market. As of September 30, 1998, 194,200 shares had been repurchased at a cost
of $731,000.

  At September 30, 1998, the Company had cash, cash equivalents, and short-term
investments of $16.3 million.  The Company regularly invests excess funds in
short-term, highly rated money market funds, government securities, and
commercial paper. The Company believes that the currently available funds and
cash generated from operations will be sufficient to meet the Company's business
requirements at least through September 30, 1999.

  At September 30, 1998, the Company had available a bank line of credit to
borrow up to $1.0 million at an interest rate of prime. There were no borrowings
under the bank line of credit for the period ended September 30, 1998.  This
bank line of credit requires the Company to maintain certain financial
covenants.  The Company was in compliance with all covenants contained in the
bank line of credit at September 30, 1998 and during the first nine months of
1998.  This bank line of credit will expire on January 31, 1999 and the Company
expects that the line of credit will be renewed on substantially similar terms.

                                       12
<PAGE>
 
YEAR 2000 DISCLOSURE
--------------------

  Historically, certain computer programs have been written using two digits,
rather than four digits, to define the applicable year. This could lead, for
example, to a computer's interpreting "00" as the year 1900 rather than the Year
2000. This phenomenon could result in major computer system failures or
miscalculations and is generally referred to as the "Year 2000" problem or
issue.

  The Company has developed a phased Year 2000 readiness plan for the current
versions of its products. The plan includes development of corporate awareness,
assessment, implementation (including remediation, upgrading and replacement of
certain product versions), validation testing, and contingency planning. The
Company continues to respond to customer concerns about prior versions of its
products on a case-by-case basis.

  The Company has defined "Year 2000 compliant" as the ability to (i) correctly
handle date information needed for the December 31, 1999 to January 1, 2000 date
change; (ii) function according to the product documentation provided for this
date change, without changes in operation resulting from the advent of a new
century, assuming correct configuration; (iii) where appropriate, respond to 
two-digit date input in a way that resolves the ambiguity as to century in a
disclosed, defined, and predetermined manner; (iv) if the date elements in
interfaces and data storage specify the century, store and provide output of
date information in ways that are unambiguous as to century; and (v) recognize
Year 2000 as a leap year. The Company has not tested its products on all
platforms or all versions of operating systems that it currently supports and
has advised its customers to verify that their platforms and operating systems
support the transition to the Year 2000.

  The Company has completed an initial review and assessment of its products
and, with the exception of the products discussed below, the Company believes
that its current products are Year 2000 compliant. For example, the Company's
core G2 product has two built-in techniques for storing and processing time and
date information. These techniques are time stamp and intervals. Time stamps are
64-bit IEEE floating point numbers. Intervals are stored as integers. Neither of
these representations imposes a practical limit on the size of the date value
stored and do not pose any problems with the passing of the millennium.
Therefore, the Company does not believe that the Company's products, except
those discussed below, will be adversely affected by date changes to the Year
2000. However, there can be no assurance that the Company's products contain and
will contain all features and functionality considered necessary by customers,
including ISVs, end users and distributors, to be Year 2000 compliant. In
addition, there can be no assurances that the Company's current products do not
contain undetected errors or defects associated with Year 2000 date functions
that may result in material costs to the Company.

  While the Company believes that current versions of its products are Year 2000
compliant, other factors may result in an application created using the
Company's products not being Year 2000 compliant. Some of these factors include
improper programming techniques used by third parties in creating the
application or non-compliance of the underlying hardware, operating system, or
third-party software on which the software runs. Known or unknown errors or
defects in the Company's products could result in delay or loss of revenue,
diversion of development resources, damage to the Company's reputation, or
increased service and warranty costs, any of which could materially adversely
affect the Company's business, operating results or financial condition. Some
commentators have predicted significant litigation regarding Year 2000
compliance issues, and the Company is aware of such lawsuits against other
software vendors. Because of the unprecedented nature of such litigation, it is
uncertain whether or to what extent the Company may be affected by it.

  Testing has revealed that a specific G2 system procedure and the use of two-
digit years in the built-in displays are not Year 2000 compliant. These problems
were fixed in G2 5.0 Rev. 3.

  The Company's internal systems include both its information technology ("IT")
and non-IT systems. The Company has initiated an assessment of its material
internal IT systems (including both 

                                       13
<PAGE>
 
the Company's own software products and third-party software and hardware
technology) and its non-IT systems. The Company expects to complete that testing
in early 1999. To the extent the Company is not able to test the technology
provided by third-party vendors, the Company is seeking assurances from such
vendors that their systems are Year 2000 compliant. Although the Company is not
currently aware of any material operational issues or costs associated with
preparing its internal IT and non-IT systems for the Year 2000, the Company may
experience material unanticipated problems and costs caused by undetected errors
or defects in the technology used in its internal IT and non-IT systems. There
can be no assurance that the Company will not experience unanticipated negative
consequences or material costs caused by undetected errors or defects in the
technology used in its internal systems.

  The Company does not currently have any information concerning the Year 2000
compliance status of its customers. As is the case with other similarly situated
software companies, if the Company's current or future customers fail to achieve
Year 2000 compliance, or if they divert technology expenditures to address Year
2000 compliance problems, the Company's business, results of operations, or
financial condition could be materially adversely affected.

  The Company has funded its Year 2000 plan from operating cash flows and has
not separately accounted for these costs in the past. The Company may incur
additional costs related to the Year 2000 plan for administrative personnel to
manage the project, outside contractor assistance, technical support for its
products, product engineering and customer satisfaction. The Company may
experience material problems and costs with Year 2000 compliance that could
adversely affect the Company's business, results of operations, and financial
condition.

  The Company has not fully developed a comprehensive contingency plan to
address situations that may result if the Company is unable to achieve Year 2000
readiness of its initial operations. The costs of developing and implementing
such plan may itself be material. The necessity of a contingency plan will be
evaluated based on the outcome of its assessment and testing of the Year 2000
readiness of material third-parties. Preparation of contingency plans is
targeted for the third quarter of 1999 (which plans will thereafter be revised
from time to time as deemed appropriate). Finally, the Company is also subject
to external forces that might generally affect industry and commerce, such as
utility company Year 2000 compliance failures and related services
interruptions.

  The Company expects to complete these assessments and testing, as well as the
testing of its internal systems, by early 1999 and does not anticipate that any
of these potential issues will have a material adverse effect on the Company's
business, financial condition and operating results.

  Additionally, there can be no assurance that the Company will not be the
subject of lawsuits regarding the failure of the Company's products (former or
present) in the event they are not Year 2000 compliant. Despite the testing and
remediation efforts undertaken by the Company, the Company's products may
contain errors or defects associated with the Year 2000. Known or unknown
errors or defects in the Company's products could result in delay or loss of
revenue, diversion of development resources, damage to the Company's reputation
or increased service and warranty costs, any of which could materially adversely
affect the Company's business, operating results and financial condition. In
addition, because the computer system in which the Company's products are used
involve different hardware, software and firmware components from different
manufacturers, it may be difficult to determine which component in a system
caused a Year 2000 issue. As a result, the Company may be subjected to 
Year 2000-related lawsuits independent of whether its products are Year 2000
compliant. Any Year 2000 related suits, if adversely determined, could have a
material adverse effect on the Company's business, operating results and
financial conditions.

  The foregoing review of the Company's Year 2000 readiness, including estimates
of the time frames and costs for addressing the known Year 2000 issues
confronting the Company, is based on management's current estimates, which were
derived using numerous assumptions. There can be no 

                                       14
<PAGE>
 
assurance that these estimates will be achieved and actual events and results
could differ materially from those anticipated. Specific factors that might
cause such material difference include, but are not limited to, the availability
of personnel with required remediation skills, the ability of the Company to
identify and correct all relevant computer code and the success of third parties
with whom the Company does business in addressing their Year 2000 issues.

                                       15
<PAGE>
 
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS

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

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

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

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

                                       16
<PAGE>
 
financial performance has generally been somewhat weaker in the first quarter
than in the other fiscal quarters, due to customer purchasing patterns.

Economic Factors and Industry Concentration.  Because capital expenditures are
often viewed as discretionary by organizations, sales of the Company's products
for capital budget projects are subject to general economic conditions.  Such
capital expenditures are also susceptible to industry-specific economic
downturns. Specifically, the Company derives a significant portion of its
revenues from the chemical and petrochemical industries.  The Company derived
19.7%, 26.8%, and 12.3% of its product revenues in the chemical and
petrochemical industries in 1996, 1997 and the first nine months of 1998,
respectively.  Accordingly, the Company's future success is dependent upon the
continued demand for process control and optimization software from companies in
the chemical and petrochemical industries.  The Company believes that economic
downturns and pricing pressures experienced by chemical and petrochemical
companies in connection with cost-containment measures have led to delays and
reductions in certain capital and operating expenditures by many of such
companies worldwide.  These industries are highly cyclical and have experienced
weakened demand in the past, which has adversely affected the Company's
revenues, gross margin, and operating results during such periods. Future
recessionary conditions in the industries which use the Company's products may
adversely affect the Company's business, results of operations, or financial
condition.

Product Concentration.  The Company's current product offerings are primarily
G2, an object-oriented development and deployment environment for building
intelligent operations management systems, and software application products
which operate in conjunction with G2.  Accordingly, the Company's business and
financial results are substantially dependent upon the continued customer
acceptance and deployment of G2 and related products.  The timing of major G2
releases may affect the timing of purchases of the Company's products.  The
Company has introduced several G2-based application-specific products and is
developing others.  The Company believes that market acceptance of these
products will be important to the Company's future growth.  There can be no
assurance that such products will achieve market acceptance or that new products
will be successfully developed.  In addition, the Company relies on many of its
marketing partners to develop G2-based products for specialized markets.
Accordingly, the Company's business and financial results are also linked to the
continued successful product development by its marketing partners and market
acceptance of such G2-based products.  Any decline in the demand for G2 and
related products, whether as a result of competitive products, price
competition, the lack of success of the Company's marketing partners,
technological change, the shift in customer demand toward complete solutions, or
other factors, could have a material adverse effect on the Company's business,
results of operations, or financial condition.

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

                                       17
<PAGE>
 
will not cause customers to defer purchasing existing Company products. See
"Emerging Market for Intelligent Operations Management Systems".

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

Reliance Upon Indirect Distribution Channels and Risks Associated with Strategic
Partner Relationships.  The Company sells its products in part through value-
added resellers, systems integrators, OEMs, and distributors, who are not under
the control of the Company.  Sales of the Company's products by value-added
resellers, systems integrators and OEMs represented 28%, 35% and 33% of the
Company's product revenues in 1996, 1997 and the first nine months of 1998,
respectively.  Sales of the Company's products to and by distributors, primarily
the Company's Japanese distributor, accounted for 14%, 8% and 3% of the
Company's product revenues in 1996, 1997 and the first nine months of 1998,
respectively.  The loss of one or more major third-party distributors, OEMs or
resellers of the Company's products, a significant decline in their sales, or
difficulty on the part of such third-party developers or resellers in developing
successful G2-based products and applications could have a material adverse
effect on the Company's business, results of operations, or financial condition.

A significant business strategy of the Company is to add resources for channel
business development and management and to expand its relationship with
strategic partners.  There can be no assurance that the Company will be able to
negotiate additional strategic partner relationships on acceptable terms or that
any such relationships, if established, will be commercially successful.  There
also can be no assurance that existing or potential partners will not pursue
alternative technologies or develop alternative products in addition to or in
lieu of the Company's products either on their own or in collaboration with
others, including the Company's competitors.  In addition, the Company relies on
third-party resellers to provide post-sales service and support to its
customers, and any deficiencies in such service and support could adversely
affect the Company's business, results of operations, or financial condition.

Risks Associated With International Operations.  The Company's international
revenues represented 42%, 46% and 44% of total revenues in 1996, 1997 and the
first nine months of 1998, respectively.  Revenues are categorized by the
Company according to product shipment destination and therefore do not
necessarily reflect the ultimate country of installation.  The international
portion of the Company's business is subject to a number of inherent risks,
including difficulties in building and managing international operations,
difficulties in localizing products and translating documentation into local
languages, fluctuations in the value of international currencies, fluctuating
import/export duties and quotas, and unexpected regulatory, economic, or
political changes in international markets.  The Company derives a portion of
its international revenues from customers in Asia, including customers in Japan.
Currency fluctuations and instability in Asian financial markets may reduce
potential customers' investment in capital projects that utilize the software
products developed and marketed by the Company and its partners.  There can be
no assurance that these factors will not adversely affect the Company's
business, results of operations, or financial condition.

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

                                       18
<PAGE>
 
software development tools that software application developers or potential
customers could use to build software having functionality similar to the
Company's products.

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

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

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

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

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

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

                                       19
<PAGE>
 
parties, or that third parties will not be able to develop similar technology
independently. In addition, there can be no assurance that third parties will
not assert infringement claims in the future or that such claims will not be
successful.

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

Year 2000 Compliance.  Many installed computer systems and software products are
coded to accept only two digit entries in the date code field.  Beginning in the
year 2000, these date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates.  Systems that do not
properly recognize such information could generate erroneous data or cause a
system to fail.  Although the Company believes that its products and systems are
Year 2000 compliant, the Company utilizes third party equipment and software
that may not be Year 2000 compliant. Known or unknown errors or defects, with
regard to the Year 2000 and thereafter, in the Company's products and systems
could result in delay or loss of revenue, diversion of development resources,
damage to the Company's reputation, increased service and warranty costs, or
significant litigation, any of which could materially adversely affect the
Company's business, operating results or financial condition. Furthermore, the
purchasing patterns of customers or potential customers may be affected by Year
2000 issues as companies expend significant resources to correct their current
systems for Year 2000 compliance.  These expenditures may result in reduced
funds available to purchase products and services such as those offered by the
Company.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

        Not Applicable

                                       20
<PAGE>
 
PART II - OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS

        None

ITEM 2. CHANGES IN SECURITIES

        None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

        None

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

        None

ITEM 5. OTHER INFORMATION

        None

ITEM 6. EXHIBITS AND REPORTS OF FORM 8-K

        (a) Exhibit Index
            Exhibit 27 - Financial Data Schedule

        (b) No reports on Form 8-K were filed by Gensym during the quarter ended
            September 30, 1998.

                                       21
<PAGE>
 
                                   SIGNATURES


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



                                       GENSYM CORPORATION
                                       (Registrant)



                                       /s/ Lowell B. Hawkinson
                                       -----------------------
       Dated:  November 13, 1998       Lowell B. Hawkinson
                                       Chairman of the Board,
                                       Chief Executive Officer
                                       and Treasurer
                                       (Principal Executive Officer and
                                       Principal Financial Officer)

                                       22