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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark one)

|x | Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended September 30, 2006

OR



| ̈ | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to
.

Commission File Number: 0-27696



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GENSYM CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 04-2932756                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer 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 ̈No  x

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, or a
non-accelerated filer. See definition of large accelerated filer in Rule 12-b-2 of the Exchange Act. (Check one):

Large
Accelerated Filer ̈Accelerated Filer ̈Non-accelerated filer  x

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

As of May 31, 2007 there were 7,878,404
shares of the Registrants Common Stock outstanding.



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INDEX



|                             |  |                                                                                                                   |  |   
|---------------------------- |  | ----------------------------------------------------------------------------------------------------------------- |  | --
|Explanatory Note             |  | 3                                                                                                                
|                             | 
|Part IFinancial Information |  |                                                                                                                  
|                             |  |                                                                                                                  
|Item 1.                      |  | Consolidated Financial Statements                                                                                 |  | 5 
|                             |  |                                                                                                                  
|                             |  | Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005 (Unaudited)                            |  | 5 
|                             |  |                                                                                                                  
|                             |  | Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 and 2005 (Unaudited) |  | 6 
|                             |  |                                                                                                                  
|                             |  | Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005 (Unaudited)           |  | 7 
|                             |  |                                                                                                                  
|                             |  | Notes to Consolidated Financial Statements                                                                        |  | 8 
|                             |  |                                                                                                                  
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                             |  | 18
|                             |  |                                                                                                                  
|Item 3.                      |  | Qualitative and Quantitative Disclosures About Market Risk                                                        |  | 26
|                             |  |                                                                                                                  
|Item 4.                      |  | Controls and Procedures                                                                                           |  | 26
|                             | 
|Part IIOther Information    |  |                                                                                                                  
|                             |  |                                                                                                                  
|Item 1.                      |  | Legal Proceedings                                                                                                 |  | 28
|                             |  |                                                                                                                  
|Item 1A.                     |  | Risk Factors                                                                                                      |  | 28
|                             |  |                                                                                                                  
|Item 2                       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                       |  | 35
|                             |  |                                                                                                                  
|Item 6.                      |  | Exhibits                                                                                                          |  | 36
|                             |  |                                                                                                                  
|                             |  | Signatures                                                                                                        |  | 36
|                             |  |                                                                                                                  
|                             |  | Exhibit Index                                                                                                     |  | 37



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GENSYM CORPORATION

EXPLANATORY NOTE

In this Quarterly Report on From 10-Q for the fiscal quarter ended September 30, 2006, we are restating our consolidated financial statements and related disclosures for the three and nine months ended
September 30, 2005. In our Form 10-K for the year ended December 31, 2006 to be filed with the Securities and Exchange Commission, we are restating our consolidated balance sheet as of December 31, 2005, and the related consolidated
statements of operations, shareholders equity and cash flows for each of the fiscal years ended December 31, 2005 and 2004 and each of the quarters in fiscal year 2005, and we believe these reflect all required restatement adjustments. We
do not anticipate filing amended Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for any periods prior to the first quarter of 2006. Accordingly, our Annual Reports on Form 10-K and our Quarterly Reports on Form 10-Q for 2000 through
2005 have not been revised to reflect the restatement and the financial statements contained in those reports should not be relied upon. Instead, the restated financial statements for 2005 and 2004 included in our Annual Report on Form 10-K for the
year ended December 31, 2006 should be relied upon. For a detailed discussion of the effect of the restatements, see Note 3, Restatement of Previously Issued Financial Statements, to the Financial Statements included in Part I,
Item 1 Consolidated Financial Statements and Part I, Item 2, Managements Discussion and Analysis of Financial Condition and Results of OperationsRestatement of Previously Issued Financial Statements.

We have identified and reported material weaknesses to the Audit Committee of our Board of Directors and Vitale, Caturano & Company,
Ltd., our independent registered public accounting firm. Please see Part I, Item 4. Controls and Procedures in Part I for a description of these matters, and of the measures that we have implemented to date, as well as additional steps
we plan to take to strengthen our controls.

We are also recording adjustments affecting our previously-reported financial statements for fiscal years 2000
through 2005 and for the first quarter of 2006, the cumulative effects of which are summarized in the table below. The financial statements for 2003, 2002, 2001, 2000 have not been audited. The restatements for all periods described in this
quarterly report on Form 10-Q, include adjustments arising from an internal review of our accounting practices with respect to three areas:



| |  |  | revenue recognition for certain software license and service agreement transactions;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | stock option practices and related stock-based compensation expense; and
| | - |  | ------------------------------------------------------------------------



| |  |  | other accounting adjustments, including foreign tax filing errors and accounting timing adjustments.
| | - |  | ----------------------------------------------------------------------------------------------------

In May 2006, our management notified our Audit Committee of the Board of Directors of concerns relating to our revenue recognition accounting for certain software
license and service agreements. The Audit Committee initiated an internal review of our revenue recognition accounting practices, notified our independent public accounting firm and engaged outside legal counsel and outside accounting specialists to
assist with its review.

On July 14, 2006, as a result of these investigations, the Audit Committee concluded, in consultation with and upon the
recommendation of management, that previously issued financial statements included in our Annual Reports on Form 10-K for the fiscal years ended December 31, 2004 and 2005 and in our Quarterly Reports on Form 10-Q for the fiscal quarters ended
March 31, June 30 and September 30, 2005 and March 31, 2006, and all of our related earnings releases and similar communications relating to all such fiscal periods, should no longer be relied upon.

On August 14, 2006, November 13, 2006 and May 22, 2007 we filed Forms 12b-25 with the Securities and Exchange Commission stating that we would be
unable to file timely quarterly reports of Form 10-Q for the fiscal quarters ended June 30, 2006, September 30, 2006 and March 31, 2007, respectively. On April 3, 2007, we filed a Form 12b-25 stating that we would be unable
to file timely our annual report on Form 10-K for the year ended December 31, 2006.

In the November 13, 2006 filing, we stated that the scope of
the Audit Committees investigation had been expanded to include software license and services agreements entered into from 2000 to 2004. We also reported that the expanded scope included a self-initiated review of historical stock option grant
practices and related accounting treatment. This review was conducted under the direction of a special committee of our Board of Directors, with the assistance of outside legal counsel and outside accounting specialists.

During the course of the reviews described above, foreign tax filing errors and certain accounting timing adjustments were also identified. For example, we were notified
in 2006 by Dutch tax authorities of errors in the tax returns of our Dutch



3



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subsidiary, Gensym BV, for 2003 and 2004 which when corrected entitled us to a refund of taxes previously paid. We also identified several intercompany items
related to the financial consolidation of our subsidiaries that were reported in incorrect accounting periods in 2003 and 2004.

Cumulative Effect of
Adjustments on Accumulated Deficit

The following table presents the cumulative effect of adjustments resulting from the reviews described above for the
periods shown.



|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|---------------------------------------- |  | --------------- | ---- | - | ---- | - | ------- | ---- |  | - | ------ | - |  | ---- | ----- | - | ---- | - | ------ | ---- |  | - | ------------------- | - |  | - | ------ | - |  | - | ----- | -
|                                         |  | 1999and Prior   |      |   | 2000 |   |         | 2001 |  |   | 2002   |   |  | 2003 |       |   | 2004 |   |        | 2005 |  |   | FirstQuarterof 2006 |  
|                                         |  | As Restated (1) |     
|                                         |  | (in thousands)  |     
|Net (Loss) income as originally reported |  | $               |     |   |      | $ | (12,816 | )    |  | $ | (3,749 | ) |  | $    | 1,644 |   |      | $ | (1,783 | )    |  | $ | 894                 |   |  | $ | (663   | ) |  | $ | (575  | )
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Adjustments related to:                  |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Revenue Recognition                      |  |                 | (790 | ) |      |   | (1,335  | )    |  |   | 1,331  |   |  |      | (103  | ) |      |   | 162    |      |  |   | 101                 |   |  |   | (579   | ) |  |   | 99    |  
|Stock Compensation                       |  |                 | (35  | ) |      |   | (120    | )    |  |   | (33    | ) |  |      | (14   | ) |      |   | (31    | )    |  |   | (15                 | ) |  |   | 6      |   |  |   |      |  
|Other Accounting Adjustments             |  |                 |     |   |      |   |        |      |  |   |       |   |  |      |      |   |      |   | 204    |      |  |   | (24                 | ) |  |   | (24    | ) |  |   | 3     |  
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Net adjustments                          |  |                 | (825 | ) |      |   | (1,455  | )    |  |   | 1,298  |   |  |      | (117  | ) |      |   | 335    |      |  |   | 62                  |   |  |   | (597   | ) |  |   | 102   |  
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Net (Loss) income as restated            |  |                 | (825 | ) |      |   | (14,271 | )    |  |   | (2,451 | ) |  |      | 1,527 |   |      |   | (1,448 | )    |  |   | 956                 |   |  |   | (1,260 | ) |  |   | (473  | )
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|                                         |  |                 |      |   |      |   |         |     
|Cumulative effect to Accumulated Deficit |  | $               | 825  |   |      | $ | 2,280   |      |  | $ | 982    |   |  | $    | 1,099 |   |      | $ | 764    |      |  | $ | 702                 |   |  | $ | 1,299  |   |  | $ | 1,197 |  
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

Additional information regarding the restatement can be found in this report in:



| |  |  | Part I, Item 1, Note 3, Restatement of Previously Issued Financial Statements;
| | - |  | --------------------------------------------------------------------------------



| |  |  | Part I, Item 2, Managements Discussion and Analysis of Financial Condition and Results of Operations  Restatement of Previously Issued
Financial Statements;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Part I, Item 4, Controls and Procedures; and
| | - |  | ----------------------------------------------



| |  |  | Part II, Item 1A, Risk Factors.
| | - |  | ---------------------------------



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PART I. FINANCIAL INFORMATION



|ITEM 1. | Consolidated Financial Statements
|------- | ---------------------------------

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share and per share amounts)



|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------- | - | -------------------------------- | - | ------- | -
|                                                                                                                                                                                                       |  | September 30, 2006 |         |   | December 31, 2005As Restated (1) |  
|ASSETS                                                                                                                                                                                                 |  |                    |         |   |                                  |   |         |  
|Current Assets:                                                                                                                                                                                        |  |                    |         |   |                                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                              |  | $                  | 3,330   |   |                                  | $ | 3,176   |  
|Accounts receivable, net of allowance for doubtful accounts of $47 at September 30, 2006 and $48 at December 31,
2005                                                                                  |  |                    | 2,862   |   |                                  |   | 3,987   |  
|Prepaid and other current assets                                                                                                                                                                       |  |                    | 518     |   |                                  |   | 345     |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|Total current assets                                                                                                                                                                                   |  |                    | 6,710   |   |                                  |   | 7,508   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|                                                                                                                                                                                                       |  |                   
|Property and equipment, net                                                                                                                                                                            |  |                    | 585     |   |                                  |   | 599     |  
|Deposits and other assets                                                                                                                                                                              |  |                    | 163     |   |                                  |   | 334     |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|Total Assets                                                                                                                                                                                           |  | $                  | 7,458   |   |                                  | $ | 8,441   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|                                                                                                                                                                                                       |  |                   
|LIABILITIES AND STOCKHOLDERS DEFICIT                                                                                                                                                                  |  |                    |         |   |                                  |   |         |  
|Current Liabilities:                                                                                                                                                                                   |  |                    |         |   |                                  |   |         |  
|Accounts payable                                                                                                                                                                                       |  | $                  | 596     |   |                                  | $ | 495     |  
|Accrued expenses                                                                                                                                                                                       |  |                    | 2,086   |   |                                  |   | 1,541   |  
|Current portion of capital lease obligation                                                                                                                                                            |  |                    | 110     |   |                                  |   | 101     |  
|Deferred revenue                                                                                                                                                                                       |  |                    | 4,230   |   |                                  |   | 5,119   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|Total current liabilities                                                                                                                                                                              |  |                    | 7,022   |   |                                  |   | 7,256   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|                                                                                                                                                                                                       |  |                   
|Capital lease and other long term liabilities, net of current portion                                                                                                                                  |  |                    | 172     |   |                                  |   | 179     |  
|Long term deferred revenue                                                                                                                                                                             |  |                    | 1,000   |   |                                  |   | 1,084   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|Total Liabilities                                                                                                                                                                                      |  | $                  | 8,194   |   |                                  | $ | 8,519   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|                                                                                                                                                                                                       |  |                   
|Commitments and contingencies                                                                                                                                                                          |  |                    |         |   |                                  |   |         |  
|Stockholders Deficit:                                                                                                                                                                                 |  |                    |         |   |                                  |   |         |  
|Preferred stock $.01 par value-authorized 2,000,000 shares issued and out standingnone                                                                                                                |  |                    |         |   |                                  |   |         |  
|Common stock $.01 par valueauthorized20,000,000 shares issued7,858,090 and 7,773,222 shares in 2006 and 2005 respectively
outstanding7,525,721 and 7,429,541 shares in 2006 and 2005, respectively |  |                    | 79      |   |                                  |   | 78      |  
|Capital in excess of par value                                                                                                                                                                         |  |                    | 22,523  |   |                                  |   | 22,372  |  
|Treasury stock332,369 shares in 2006 and 343,681 shares in 2005 at cost respectively                                                                                                                  |  |                    | (1,240  | ) |                                  |   | (1,282  | )
|Accumulated deficit                                                                                                                                                                                    |  |                    | (22,081 | ) |                                  |   | (21,215 | )
|Accumulated other comprehensive income                                                                                                                                                                 |  |                    | (17     | ) |                                  |   | (31     | )
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|Total stockholders deficit                                                                                                                                                                            |  |                    | (736    | ) |                                  |   | (78     | )
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  
|Total liabilities and stockholders deficit                                                                                                                                                            |  | $                  | 7,458   |   |                                  | $ | 8,441   |  
|                                                                                                                                                                                                       |  |                    |         |   |                                  |   |         |  

The accompanying notes are an integral part of these unaudited Consolidated Financial Statements.

(1) See Note 3, to the Consolidated Financial Statements



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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share
amounts)



|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|------------------------------------------------------------ |  | ------------------------------- | ----- | - | ------------------------------ | - | ------ | ---- |  | - | ------------------- | - |  | - | ------ | -
|                                                             |  | Three Months EndedSeptember 30, |       |   | Nine Months EndedSeptember 30, |  
|                                                             |  | 2006                            |       |   | 2005As Restated (1)            |   |        | 2006 |  |   | 2005As Restated (1) |  
|Revenues:                                                    |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Product                                                      |  | $                               | 1,006 |   |                                | $ | 811    |      |  | $ | 4,326               |   |  | $ | 4,416  |  
|Services                                                     |  |                                 | 3,377 |   |                                |   | 2,325  |      |  |   | 8,397               |   |  |   | 8,085  |  
|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Total Revenues                                               |  |                                 | 4,383 |   |                                |   | 3,136  |      |  |   | 12,723              |   |  |   | 12,501 |  
|                                                             |  |                                 |       |  
|Cost of revenues:                                            |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Product                                                      |  |                                 | 112   |   |                                |   | 115    |      |  |   | 339                 |   |  |   | 370    |  
|Services                                                     |  |                                 | 1,387 |   |                                |   | 995    |      |  |   | 3,485               |   |  |   | 3,427  |  
|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Total cost of revenues                                       |  |                                 | 1,499 |   |                                |   | 1,110  |      |  |   | 3,824               |   |  |   | 3,797  |  
|                                                             |  |                                 |       |  
|Gross Profit                                                 |  |                                 | 2,884 |   |                                |   | 2,026  |      |  |   | 8,899               |   |  |   | 8,704  |  
|                                                             |  |                                 |       |  
|Operating Expenses:                                          |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Sales and marketing                                          |  |                                 | 974   |   |                                |   | 1,142  |      |  |   | 3,391               |   |  |   | 3,851  |  
|Research and development                                     |  |                                 | 701   |   |                                |   | 970    |      |  |   | 2,401               |   |  |   | 2,988  |  
|General and administrative                                   |  |                                 | 1,123 |   |                                |   | 981    |      |  |   | 3,416               |   |  |   | 3,145  |  
|Restructuring                                                |  |                                 | 544   |   |                                |   |       |      |  |   | 544                 |   |  |   |       |  
|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Total operating expenses                                     |  |                                 | 3,342 |   |                                |   | 3,093  |      |  |   | 9,752               |   |  |   | 9,984  |  
|                                                             |  |                                 |       |  
|Operating Loss                                               |  |                                 | (458  | ) |                                |   | (1,067 | )    |  |   | (853                | ) |  |   | (1,280 | )
|Other income (expense), net                                  |  |                                 | 1     |   |                                |   | (67    | )    |  |   | 26                  |   |  |   | (89    | )
|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|                                                             |  |                                 |       |  
|Loss before provision for income taxes                       |  |                                 | (457  | ) |                                |   | (1,134 | )    |  |   | (827                | ) |  |   | (1,369 | )
|Provision (benefit) for income taxes                         |  |                                 | 7     |   |                                |   | (18    | )    |  |   | 16                  |   |  |   | 6      |  
|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Net loss                                                     |  | $                               | (464  | ) |                                | $ | (1,116 | )    |  | $ | (843                | ) |  | $ | (1,375 | )
|                                                             |  |                                 |       |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|                                                             |  |                                 |       |  
|Basic and diluted loss per share                             |  | $                               | (0.06 | ) |                                | $ | (0.15  | )    |  | $ | (0.11               | ) |  | $ | (0.19  | )
|                                                             |  |                                 |       |  
|Basic and diluted weighted average common shares outstanding |  |                                 | 7,477 |   |                                |   | 7,367  |      |  |   | 7,459               |   |  |   | 7,304  |  

The accompanying notes are an integral part of these unaudited Consolidated Financial Statements.

(1) See Note 3, to the Consolidated Financial Statements



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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                         |  |                                 |       |   |                     |   |        |  
|---------------------------------------------------------------------------------------- |  | ------------------------------- | ----- | - | ------------------- | - | ------ | -
|                                                                                         |  | Nine Months Ended September 30, |      
|                                                                                         |  | 2006                            |       |   | 2005As Restated (1) |  
|Cash Flows from Operating Activities:                                                    |  |                                 |       |   |                     |   |        |  
|Net loss                                                                                 |  | $                               | (843  | ) |                     | $ | (1,375 | )
|Adjustments to reconcile net (loss) income to net cash provided by operating activities: |  |                                 |       |   |                     |   |        |  
|Depreciation and amortization                                                            |  |                                 | 254   |   |                     |   | 418    |  
|Stock-based compensation                                                                 |  |                                 | 131   |   |                     |   | 63     |  
|Loss on disposal of equipment                                                            |  |                                 |      |   |                     |   | 3      |  
|Reversal of provision for bad debt                                                       |  |                                 | (1    | ) |                     |   | (94    | )
|Changes in assets and liabilities:                                                       |  |                                 |       |   |                     |   |        |  
|Accounts receivable                                                                      |  |                                 | 1,126 |   |                     |   | 1,710  |  
|Prepaid expenses and other current assets                                                |  |                                 | (23   | ) |                     |   | (123   | )
|Accounts payable                                                                         |  |                                 | 101   |   |                     |   | (52    | )
|Accrued expenses                                                                         |  |                                 | 545   |   |                     |   | (509   | )
|Deferred revenue                                                                         |  |                                 | (973  | ) |                     |   | 102    |  
|Other liabilities                                                                        |  |                                 | 55    |   |                     |   |       |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|Net cash provided by operating activities                                                |  |                                 | 372   |   |                     |   | 143    |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|                                                                                         |  |                                
|Cash Flows from Investing Activities:                                                    |  |                                 |       |   |                     |   |        |  
|Purchases of property and equipment                                                      |  |                                 | (192  | ) |                     |   | (295   | )
|Decrease in other assets                                                                 |  |                                 |      |   |                     |   | 360    |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|Net cash (used in) provided by investing activities                                      |  |                                 | (192  | ) |                     |   | 65     |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|                                                                                         |  |                                
|Cash Flows From Financing Activities:                                                    |  |                                 |       |   |                     |   |        |  
|Principal payments on capital lease obligations                                          |  |                                 | (80   | ) |                     |   | (85    | )
|Proceeds from exercise of stock options                                                  |  |                                 | 40    |   |                     |   | 142    |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|Net cash (used in) provided by financing activities                                      |  |                                 | (40   | ) |                     |   | 57     |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|                                                                                         |  |                                
|Effect of Exchange Rate Changes on Cash                                                  |  |                                 | 14    |   |                     |   | (196   | )
|                                                                                         |  |                                 |       |   |                     |   |        |  
|Net Increase in Cash and Cash Equivalents                                                |  |                                 | 154   |   |                     |   | 69     |  
|Cash and Cash Equivalents, Beginning of Period                                           |  |                                 | 3,176 |   |                     |   | 2,927  |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|                                                                                         |  |                                
|Cash and Cash Equivalents, End of Period                                                 |  | $                               | 3,330 |   |                     | $ | 2,996  |  
|                                                                                         |  |                                 |       |   |                     |   |        |  
|                                                                                         |  |                                
|Cash paid for income taxes                                                               |  | $                               | 10    |   |                     | $ |       |  
|                                                                                         |  |                                
|Cash paid for interest                                                                   |  | $                               | 14    |   |                     | $ | 18     |  
|                                                                                         |  |                                
|Acquisition (divestiture) of equipment under capital lease obligations                   |  | $                               | 27    |   |                     | $ | (130   | )

The accompanying notes are an integral part of these unaudited Consolidated Financial Statements.

(1) See Note 3, to the Consolidated Financial Statements



7



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Operations

We are a provider of rule engine software and services for mission-critical solutions that support and automate
decisions in real time. Our flagship G2©software applies real-time rule technology for
decisions that optimize operations and that detect, diagnose, and resolve costly problems. With applications based on G2, organizations in manufacturing, utilities, communications, transportation, aerospace, finance, and government increase the
agility of their business operations and achieve greater levels of performance.

2. Basis of Presentation

We have prepared the unaudited consolidated financial statements included in this report 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, our management believes that the disclosures in this report 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 as well as the restated adjustments described in Note 3) that are necessary to present fairly our consolidated financial position as of
September 30, 2006 and December 31, 2005 and our results of operations and cash flows for the three- and nine- month periods ended September 30, 2006 and 2005. These consolidated financial statements and notes thereto should be read
in conjunction with the restated consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2006, filed with the SEC on June 6, 2007. 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.

During the three- and nine- month
periods ended September 30, 2006, we incurred operating and net losses. For the nine month period ended September 30, 2006 we achieved positive cash flow. During the year ended December 31, 2005, we also incurred operating and net
losses, but achieved positive cash flow. We believe that our cash and cash equivalent balance 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. Our ability to restore growth and profitability in 2006 and beyond is dependent on market acceptance of our existing and next generation of G2 and G2-based products and related services and on renewal of maintenance contracts for customer
support at near-current levels.

Managements expectations for future revenue growth, profitability, and operating cash flows involve significant
judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure that we maintain positive cash
and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.

3. Restatement of Previously Issued Financial Statements.

Background of the Restatement of Condensed Consolidated Financial Statements
and Remedial Measures.

Review of Accounting for Software License and Service Agreement Transactions

On July 19, 2006, we announced that our Audit Committee had commenced a review of the revenue recognition accounting for certain software license and service
agreement transactions entered into during fiscal 2004 and 2005. The Audit Committee notified our independent registered public accounting firm and engaged outside legal counsel and outside accounting specialists to assist it with the review.

Based on its preliminary review as of the announcement date, the Audit Committee concluded, in consultation with and upon the recommendation of
management, that previously issued financial statements included in our Annual Reports on Form 10-K for the fiscal years ended December 31, 2004 and 2005 and in our Quarterly Reports on Form 10-Q for the fiscal quarters ended
March 31, June 30 and September 30, 2005 and March 31, 2006, and all of our related earnings releases and similar communications relating to all such fiscal periods, should no longer be relied upon.



8



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



Under the direction of the Audit Committee and the supervision of our Chief Executive Officer and Chief Financial
Officer, and with the assistance of outside legal counsel and outside accounting specialists, our accounting staff performed extensive analyses of sales orders. The original documentation for software license and service agreement transactions
recorded

between January 1, 2000 and March 31, 2006 was reviewed, including a risk assessment on each transaction based on characteristics
determined to indicate potential for incorrect accounting treatment  among those characteristics were:



| |  |  | non-standard maintenance terms
| | - |  | ------------------------------



| |  |  | extended payment terms
| | - |  | ----------------------



| |  |  | license upgrades without associated maintenance
| | - |  | -----------------------------------------------



| |  |  | temporary access codes
| | - |  | ----------------------



| |  |  | return or upgrade rights with distributors and resellers
| | - |  | --------------------------------------------------------



| |  |  | consulting services provided beyond those considered routine
| | - |  | ------------------------------------------------------------



| |  |  | delayed delivery
| | - |  | ----------------



| |  |  | orders containing references to earlier transactions
| | - |  | ----------------------------------------------------

The review of the documentation and the risk assessment were performed by employees knowledgeable about our products, services and customers, with the assistance of outside legal counsel and outside accounting specialists.

When the risk assessment indicated potential for accounting problems, the accounting treatment as originally recorded was reviewed to determine whether the order had
been accounted for correctly. The original and the corrected accounting treatments were compared, with differences (amount and timing) accumulated appropriately to support restatement. The results of this investigation revealed that revenue for some
transactions had been recognized before one or more of the required criteria for revenue recognition were met. As a result, we have recorded adjustments to our historical financial results relating to the timing of the recognition of revenue and the
allocation of revenue between license fees and maintenance. These adjustments are summarized below, and generally have the effect of deferring revenue previously recognized until later periods.

On August 14, 2006, November 13, 2006 and May 22, 2007 we filed Forms 12b-25 with the Securities and Exchange Commission stating that we would be
unable to file timely quarterly reports of Form 10-Q for the fiscal quarters ended June 30, 2006, September 30, 2006 and March 31, 2007, respectively. On April 3, 2007, we filed a Form 12b-25 stating that we would be unable
to file timely our annual report on Form 10-K for the year ended December 31, 2006.

In the November 13, 2006 filing, we stated that the scope of
the Audit Committees investigation had been expanded to include software license and services agreements entered into from 2000 to 2004. We also reported that the expanded scope included a self-initiated review of historical stock option grant
practices and related accounting treatment.

Review of Stock Option Practices and Related Stock-Based Compensation Expense

Under the direction of a special committee of the Board of Directors, we also conducted an internal review relating to our stock option grants and stock option practices.
The special committee, with the assistance of outside legal counsel and outside accounting specialists, reviewed the stock option grants to our officers, directors and employees from January 1, 1996 to March 31, 2006 under our various
stock option plans in effect during this period. The special committee also retained separate legal counsel to support its review.

Our accounting
staff has also reviewed the stock option grants and stock option practices during this period. For each award, the accounting staff reviewed the applicable option agreement, the applicable stock option plan, documentation authorizing the award and
documentation supporting the optionees date of hire and/or date of termination as well as the accounting rules in effect at the time. We use a commercially available software tool called Equity Edge to track and value our option grants. Equity
Edge assists us in the calculation of stock compensation expense based upon the information entered on the date of grant. Among the practices identified that resulted in incorrect accounting treatment were the following:



| |  |  | new hire awards with grant dates and prices inconsistent with the date of hire;
| | - |  | -------------------------------------------------------------------------------



9



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



| |  |  | awards with grant dates and/or exercise prices that differed from those authorized;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | awards for which the data input into Equity Edge differed from the documentation; and
| | - |  | -------------------------------------------------------------------------------------



| |  |  | awards granted with exercise prices lower than fair market value on the date of grant or without proper authorization.
| | - |  | ----------------------------------------------------------------------------------------------------------------------

The special committee of the Board received regular detailed status reports and reviewed the data with outside legal counsel and outside accounting specialists as it
deemed necessary.

During the stock option review process, we determined that two grants under our 1987 Stock Plan representing 1,440 and 960 shares
previously reported with an expiration date of November 20, 2008 should have expired on January, 7 2003 and September 10, 2002 respectively. Our outstanding stock option reports have been restated to reflect this correction.

Internal Revenue Code Section 421 prohibits the granting of Incentive Stock Options, referred to as ISOs, with an exercise price below fair market value of the
underlying common stock on the date of grant. For those options which were intended to be ISOs but which we subsequently determined had exercise prices below the fair market value of the underlying common stock on the date of grant, we accrued
Federal and state income taxes, payroll taxes, penalties and interest at the applicable rates, if the income was not reported on the individuals Form W-2. Our total additional expense for the accrued taxes, penalties and interest was under
$8,000.

Our review of historic stock option granting practices did not uncover systematic backdating or other errors related to option grants. We did,
however, identify mistakes in accounting for certain option grants where the measurement date for accounting purposes was incorrectly applied. As a result, we are required to record non-cash adjustments for stock-based compensation expense in
accordance with Accounting Principle Board Opinion No. 25, Accounting for Stock Issued to Employees, as summarized below.

Other Accounting
Adjustments

During the course of the reviews described above, foreign tax filing errors and certain accounting timing adjustments were identified. We
were notified in 2006 by Dutch tax authorities of errors in the tax returns of our Dutch subsidiary, Gensym BV, for 2003 and 2004 which, when corrected, entitled us to a refund of taxes previously paid. We also identified several items related to
our consolidation and treatment of certain intercompany items that were reported in incorrect accounting periods in 2003 and 2004.

Findings,
Restatement and Remediation

In connection with the findings of our review of accounting for certain software license and service agreement
transactions, we have implemented enhanced accounting policies and internal controls, as well as improved sales policies and procedures relating to sales, license delivery, consulting management and product exchanges and returns. We have also begun
to strengthen our financial reporting competencies, develop internal controls and compliance training programs, implement personnel changes where necessary and establish corporate policies, practices and controls which are clear, concise and
consistent.

Cumulative Effect of Adjustments on Accumulated Deficit

The following table presents the cumulative effect of adjustments resulting from the reviews described above for the periods shown.



|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|---------------------------------------- |  | --------------- | ---- | - | ---- | - | ------- | ---- |  | - | ------ | - |  | ---- | ----- | - | ---- | - | ------ | ---- |  | - | ------------------- | - |  | - | ------ | - |  | - | ----- | -
|                                         |  | 1999and Prior   |      |   | 2000 |   |         | 2001 |  |   | 2002   |   |  | 2003 |       |   | 2004 |   |        | 2005 |  |   | FirstQuarterof 2006 |  
|                                         |  | As Restated (1) |     
|                                         |  | (in thousands)  |     
|Net (Loss) income as originally reported |  | $               |     |   |      | $ | (12,816 | )    |  | $ | (3,749 | ) |  | $    | 1,644 |   |      | $ | (1,783 | )    |  | $ | 894                 |   |  | $ | (663   | ) |  | $ | (575  | )
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Adjustments related to:                  |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Revenue Recognition                      |  |                 | (790 | ) |      |   | (1,335  | )    |  |   | 1,331  |   |  |      | (103  | ) |      |   | 162    |      |  |   | 101                 |   |  |   | (579   | ) |  |   | 99    |  
|Stock Compensation                       |  |                 | (35  | ) |      |   | (120    | )    |  |   | (33    | ) |  |      | (14   | ) |      |   | (31    | )    |  |   | (15                 | ) |  |   | 6      |   |  |   |      |  
|Other Accounting Adjustments             |  |                 |     |   |      |   |        |      |  |   |       |   |  |      |      |   |      |   | 204    |      |  |   | (24                 | ) |  |   | (24    | ) |  |   | 3     |  
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Net adjustments                          |  |                 | (825 | ) |      |   | (1,455  | )    |  |   | 1,298  |   |  |      | (117  | ) |      |   | 335    |      |  |   | 62                  |   |  |   | (597   | ) |  |   | 102   |  
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|Net (Loss) income as restated            |  |                 | (825 | ) |      |   | (14,271 | )    |  |   | (2,451 | ) |  |      | 1,527 |   |      |   | (1,448 | )    |  |   | 956                 |   |  |   | (1,260 | ) |  |   | (473  | )
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  
|                                         |  |                 |      |   |      |   |         |     
|Cumulative effect to Accumulated Deficit |  | $               | 825  |   |      | $ | 2,280   |      |  | $ | 982    |   |  | $    | 1,099 |   |      | $ | 764    |      |  | $ | 702                 |   |  | $ | 1,299  |   |  | $ | 1,197 |  
|                                         |  |                 |      |   |      |   |         |      |  |   |        |   |  |      |       |   |      |   |        |      |  |   |                     |   |  |   |        |   |  |   |       |  

---

|(1) | See Note 3, to the Consolidated Financial Statements
|--- | ----------------------------------------------------



10



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



The tables below set forth the effect of the adjustments as of September 30, 2005 and December 31, 2005 and
for the three- and nine- month periods ended September 30, 2005 as applicable:

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share and per share amounts)



|                                                                                                                            |  |                   |         |   |             |   |         |  
|--------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------- | - | ------- | -
|                                                                                                                            |  | December 31, 2005 |        
|                                                                                                                            |  | As reported       |         |   | As Restated |  
|ASSETS                                                                                                                      |  |                   |         |   |             |   |         |  
|Current Assets:                                                                                                             |  |                   |         |   |             |   |         |  
|Cash and cash equivalents                                                                                                   |  | $                 | 3,176   |   |             | $ | 3,176   |  
|Accounts receivable, net of allowance for doubtful accounts of $47 at September 30, 2006 and $48 at December 31,
2005       |  |                   | 3,987   |   |             |   | 3,987   |  
|Prepaid and other current assets                                                                                            |  |                   | 336     |   |             |   | 345     |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|Total current assets                                                                                                        |  |                   | 7,499   |   |             |   | 7,508   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|                                                                                                                            |  |                  
|Property and equipment, net                                                                                                 |  |                   | 599     |   |             |   | 599     |  
|Deposits and other assets                                                                                                   |  |                   | 153     |   |             |   | 334     |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|Total Assets                                                                                                                |  | $                 | 8,251   |   |             | $ | 8,441   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|                                                                                                                            |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                        |  |                   |         |   |             |   |         |  
|Current Liabilities:                                                                                                        |  |                   |         |   |             |   |         |  
|Accounts payable                                                                                                            |  | $                 | 495     |   |             | $ | 495     |  
|Accrued expenses                                                                                                            |  |                   | 1,533   |   |             |   | 1,541   |  
|Current portion of capital lease obligation                                                                                 |  |                   | 101     |   |             |   | 101     |  
|Deferred revenue                                                                                                            |  |                   | 4,740   |   |             |   | 5,119   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|Total current liabilities                                                                                                   |  |                   | 6,869   |   |             |   | 7,256   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|                                                                                                                            |  |                  
|Capital lease and other long term liabilities, net of current portion                                                       |  |                   | 179     |   |             |   | 179     |  
|Long term deferred revenue                                                                                                  |  |                   | 206     |   |             |   | 1,084   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|Total Liabilities                                                                                                           |  |                   | 7,254   |   |             |   | 8,519   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  
|                                                                                                                            |  |                  
|Commitments and contingencies                                                                                               |  |                   |         |   |             |   |         |  
|Stockholders Equity:                                                                                                       |  |                   |         |   |             |   |         |  
|Preferred stock $.01 par value-authorized 2,000,000 shares issued and out standingnone                                     |  |                   |         |   |             |   |         |  
|Common stock $.01 par valueauthorized20,000,000 shares issued7,773,222 shares outstanding7,429,541 shares,
respectively |  |                   | 78      |   |             |   | 78      |  
|Capital in excess of par value                                                                                              |  |                   | 22,148  |   |             |   | 22,372  |  
|Treasury stock343,681 shares in 2005 at cost                                                                               |  |                   | (1,282  | ) |             |   | (1,282  | )
|Accumulated deficit                                                                                                         |  |                   | (19,916 | ) |             |   | (21,215 | )
|Accumulated other comprehensive income                                                                                      |  |                   | (31     | ) |             |   | (31     | )
|                                                                                                                            |  |                   |         |   |             |   |         |  
|Total stockholders equity                                                                                                  |  |                   | 997     |   |             |   | (78     | )
|                                                                                                                            |  |                   |         |   |             |   |         |  
|Total liabilities and stockholders equity                                                                                  |  | $                 | 8,251   |   |             | $ | 8,441   |  
|                                                                                                                            |  |                   |         |   |             |   |         |  



11



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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)



|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|------------------------------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | --------------- |  | - | --------------- | - |  | - | ------ | -
|                                                             |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                             |  | 2005As Reported                 |        |   | 2005As Restated                |   |        | 2005As Reported |  |   | 2005As Restated |  
|Revenues:                                                    |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|Product                                                      |  | $                               | 830    |   |                                | $ | 811    |                 |  | $ | 4,868           |   |  | $ | 4,416  |  
|Services                                                     |  |                                 | 2,375  |   |                                |   | 2,325  |                 |  |   | 8,138           |   |  |   | 8,085  |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|Total revenues                                               |  |                                 | 3,205  |   |                                |   | 3,136  |                 |  |   | 13,006          |   |  |   | 12,501 |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Cost of revenues:                                            |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Product                                                      |  |                                 | 115    |   |                                |   | 115    |                 |  |   | 370             |   |  |   | 370    |  
|Services                                                     |  |                                 | 995    |   |                                |   | 995    |                 |  |   | 3,427           |   |  |   | 3,427  |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|Total cost of revenues                                       |  |                                 | 1,110  |   |                                |   | 1,110  |                 |  |   | 3,797           |   |  |   | 3,797  |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Gross profit                                                 |  |                                 | 2,095  |   |                                |   | 2,026  |                 |  |   | 9,209           |   |  |   | 8,704  |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Operating expenses:                                          |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|Sales and marketing                                          |  |                                 | 1,142  |   |                                |   | 1,142  |                 |  |   | 3,851           |   |  |   | 3,851  |  
|Research and development                                     |  |                                 | 970    |   |                                |   | 970    |                 |  |   | 2,988           |   |  |   | 2,988  |  
|General and administrative                                   |  |                                 | 979    |   |                                |   | 981    |                 |  |   | 3,139           |   |  |   | 3,145  |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|Total operating expenses                                     |  |                                 | 3,091  |   |                                |   | 3,093  |                 |  |   | 9,978           |   |  |   | 9,984  |  
|                                                             |  |                                 |        |  
|Operating loss                                               |  |                                 | (996   | ) |                                |   | (1,067 | )               |  |   | (769            | ) |  |   | (1,280 | )
|Other expense, net                                           |  |                                 | 61     |   |                                |   | 67     |                 |  |   | 67              |   |  |   | 89     |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Loss before provision for income taxes                       |  |                                 | (1,057 | ) |                                |   | (1,134 | )               |  |   | (836            | ) |  |   | (1,369 | )
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|(Benefit) provision for income taxes                         |  |                                 | (18    | ) |                                |   | (18    | )               |  |   | 6               |   |  |   | 6      |  
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Net loss                                                     |  | $                               | (1,039 | ) |                                | $ | (1,116 | )               |  | $ | (842            | ) |  | $ | (1,375 | )
|                                                             |  |                                 |        |   |                                |   |        |                 |  |   |                 |   |  |   |        |  
|                                                             |  |                                 |        |  
|Basic and diluted loss per share                             |  | $                               | (0.14  | ) |                                | $ | (0.15  | )               |  | $ | (0.12           | ) |  | $ | (0.19  | )
|                                                             |  |                                 |        |  
|Basic and diluted weighted average common shares outstanding |  |                                 | 7,367  |   |                                |   | 7,367  |                 |  |   | 7,304           |   |  |   | 7,304  |  



12



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                         |  |                                |       |   |                 |   |        |  
|---------------------------------------------------------------------------------------- |  | ------------------------------ | ----- | - | --------------- | - | ------ | -
|                                                                                         |  | Nine Months EndedSeptember 30, |      
|                                                                                         |  | 2005As Reported                |       |   | 2005As Restated |  
|Cash Flows from Operating Activities:                                                    |  |                                |       |   |                 |   |        |  
|Net (loss) income                                                                        |  | $                              | (842  | ) |                 | $ | (1,375 | )
|Adjustments to reconcile net (loss) income to net cash provided by operating activities: |  |                                |       |   |                 |   |        |  
|Depreciation and amortization                                                            |  |                                | 418   |   |                 |   | 418    |  
|Loss on disposal of equipment                                                            |  |                                | 3     |   |                 |   | 3      |  
|Stock-based compensation                                                                 |  |                                | 57    |   |                 |   | 63     |  
|Reversal of provision for bad debt                                                       |  |                                | (94   | ) |                 |   | (94    | )
|Changes in assets and liabilities:                                                       |  |                                |       |   |                 |   |        |  
|Accounts receivable                                                                      |  |                                | 1,710 |   |                 |   | 1,710  |  
|Prepaid expenses and other current assets                                                |  |                                | (173  | ) |                 |   | (123   | )
|Accounts payable                                                                         |  |                                | (52   | ) |                 |   | (52    | )
|Accrued expenses                                                                         |  |                                | (480  | ) |                 |   | (409   | )
|Deposits and other assets                                                                |  |                                |      |   |                 |   |       |  
|Deferred revenue                                                                         |  |                                | (404  | ) |                 |   | 102    |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|Net cash provided by operating activities                                                |  |                                | 143   |   |                 |   | 143    |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|                                                                                         |  |                               
|Cash Flows from Investing Activities:                                                    |  |                                |       |   |                 |   |        |  
|Purchases of property and equipment                                                      |  |                                | (295  | ) |                 |   | (295   | )
|Decrease in other assets                                                                 |  |                                | 360   |   |                 |   | 360    |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|Net cash provided by in investing activities                                             |  |                                | 65    |   |                 |   | 65     |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|                                                                                         |  |                               
|Cash Flows From Financing Activities:                                                    |  |                                |       |   |                 |   |        |  
|Principal payments on capital lease obligations                                          |  |                                | (85   | ) |                 |   | (85    | )
|Proceeds from exercise of stock options                                                  |  |                                | 142   |   |                 |   | 142    |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|Net cash provided by financing activities                                                |  |                                | 57    |   |                 |   | 57     |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|                                                                                         |  |                               
|Effect of Exchange Rate Changes on Cash                                                  |  |                                | (196  | ) |                 |   | (196   | )
|                                                                                         |  |                                |       |   |                 |   |        |  
|Net Increase in Cash and Cash Equivalents                                                |  |                                | 69    |   |                 |   | 69     |  
|Cash and Cash Equivalents, Beginning of Period                                           |  |                                | 2,927 |   |                 |   | 2,927  |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|Cash and Cash Equivalents, End of Period                                                 |  | $                              | 2,996 |   |                 | $ | 2,996  |  
|                                                                                         |  |                                |       |   |                 |   |        |  
|                                                                                         |  |                               
|Cash paid for income taxes                                                               |  | $                              | 11    |   |                 | $ |       |  
|                                                                                         |  |                               
|Cash paid for interest                                                                   |  | $                              | 5     |   |                 | $ | 18     |  
|                                                                                         |  |                               
|Divesture of equipment under capital lease obligations                                   |  | $                              | (130  | ) |                 | $ | (130   | )



13



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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



4. Comprehensive Loss

The components of comprehensive loss for the three- and nine- month periods ended September 30, 2006 and 2005 are as follows (in thousands):



|                                        |  |                                 |      |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|--------------------------------------- |  | ------------------------------- | ---- | - | ------------------------------ | - | ------ | ---- |  | - | ------------------- | - |  | - | ------ | -
|                                        |  | Three Months EndedSeptember 30, |      |   | Nine Months EndedSeptember 30, |  
|                                        |  | 2006                            |      |   | 2005As Restated (1)            |   |        | 2006 |  |   | 2005As Restated (1) |  
|Net loss                                |  | $                               | (464 | ) |                                | $ | (1,116 | )    |  | $ | (843                | ) |  | $ | (1,375 | )
|Other comprehensive (loss) income:      |  |                                 |      |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Foreign currency translation adjustment |  |                                 | (3   | ) |                                |   | 10     |      |  |   | 14                  |   |  |   | (171   | )
|                                        |  |                                 |      |   |                                |   |        |      |  |   |                     |   |  |   |        |  
|Comprehensive loss                      |  | $                               | (467 | ) |                                | $ | (1,106 | )    |  | $ | (829                | ) |  | $ | (1,546 | )

---

|(1) | See Note 3, to the Consolidated Financial Statements
|--- | ----------------------------------------------------

5. Net Loss Per
Share

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



|                                             |  |                                 |  |                                |  |       |  |      
|-------------------------------------------- |  | ------------------------------- |  | ------------------------------ |  | ----- |  | -----
|                                             |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30,
|                                             |  | 2006                            |  | 2005                           |  | 2006  |  | 2005 
|Weighted average common shares outstanding   |  | 7,477                           |  | 7,367                          |  | 7,459 |  | 7,304
|Additional dilutive common stock equivalents |  |                                |  |                               |  |      |  |     
|                                             |  |                                 |  |                                |  |       |  |      
|Diluted weighted average shares              |  | 7,477                           |  | 7,367                          |  | 7,459 |  | 7,304
|                                             |  |                                 |  |                                |  |       |  |      

For the nine- month periods ended September 30, 2006 and 2005, options to purchase 1,230,123 and 1,647,456
shares of common stock, respectively, were outstanding, but were not included in the computation of diluted earnings per share because we had a net loss for the periods.

6. Stock Based Compensation

We issue stock options to our employees and outside directors and provide employees the
right to purchase stock pursuant to stockholder approved stock option plans.

Prior to January 1, 2006, we accounted for employee stock-based
compensation using the intrinsic value based method as prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and related interpretations. Accordingly, no compensation expense
was required to be recognized as long as the exercise price of our stock options was equal to the market price of the underlying stock on the date of grant.

Effective January 1, 2006, we adopted Statement of Financial Accounting Standard (SFAS) No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123R). Under the provisions of SFAS No. 123R, we recognize
the fair value of stock compensation in net income, over the requisite service period of the individual grantees, which generally equals the vesting period. All of our stock compensation is accounted for as equity instruments and there have been no
liability awards granted.

We have elected the modified prospective transition method for adopting SFAS No. 123R. Under this method, the provisions of
SFAS No. 123R apply to all awards granted or modified after the date of adoption. The unrecognized expense of awards not yet vested at the date of adoption are recognized in net income in the periods after the date of adoption using the same
valuation method (i.e. Black-Scholes) and assumptions determined under the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as disclosed in our previous filings. Accordingly, prior period financials
have not been restated for this purpose. Under the provisions of SFAS 123(R), we recorded a net reduction of expense of $46,000 and an expense of $121,000 of stock-based compensation on our consolidated condensed statements of operations for the
three- and nine- months ended September 30, 2006, including no compensation related to the issuance of shares of common stock to our board of directors members for the three-month period ended September 30, 2006 and $10,000 of compensation
related to the issuance of 5,306 shares of common stock to our board of directors members for the nine-month period ended September 30, 2006. The stock-based compensation for the three and nine months ended September 30, 2006 is included
in the following expense categories (in thousands):



14



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



|                           |  |                                      |     |   |                                     |   |    
|-------------------------- |  | ------------------------------------ | --- | - | ----------------------------------- | - | ---
|                           |  | Three Months EndedSeptember 30, 2006 |     |   | Nine Months EndedSeptember 30, 2006
|Cost of service and other  |  | $                                    | 2   |   |                                     | $ | 8  
|Selling and marketing      |  |                                      | 5   |   |                                     |   | 20 
|Research and development   |  |                                      | 1   |   |                                     |   | 11 
|General and administrative |  |                                      | (54 | ) |                                     |   | 82 
|                           |  |                                      |     |   |                                     |   |    
|                           |  | $                                    | (46 | ) |                                     | $ | 121
|                           |  |                                      |     |   |                                     |   |    

During the nine months ended September 31, 2006, we also issued 6,006 shares of common stock with a fair
value of $10,000 to members of management in lieu of cash payment for a portion of their bonus accrued in 2005. This amount was excluded from the table above.

The adoption of SFAS No. 123R had no effect on cash flow from operations for the three and nine months ended September 30, 2006.

SFAS
No. 123R requires the presentation of pro forma information for the comparative period prior to the adoption as if all of our employee stock options had been accounted for under the fair value method of the original SFAS No. 123. The
following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation to the prior-year period (in thousands, except per share
data).



|                                                                                                                           |  |                                      |        |   |                                     |   |        |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | ------ | - | ----------------------------------- | - | ------ | -
|                                                                                                                           |  | Three Months EndedSeptember 30, 2005 |        |   | Nine Months EndedSeptember 30, 2005 |  
|                                                                                                                           |  | As Restated (1)                      |       
|Net loss attributable to common shareholders                                                                              |  |                                      |        |   |                                     |   |        |  
|As reported                                                                                                                |  | $                                    | (1,116 | ) |                                     | $ | (1,375 | )
|Less: Stock-based compensation expense determined under fair value based method for all awards, net of related tax effects |  |                                      | 108    |   |                                     |   | 371    |  
|Add: Stock-based compensation expense included in reported net income                                                      |  |                                      | 11     |   |                                     |   | 34     |  
|                                                                                                                           |  |                                      |        |   |                                     |   |        |  
|Pro forma net loss                                                                                                         |  | $                                    | (1,213 | ) |                                     | $ | (1,712 | )
|                                                                                                                           |  |                                      |        |   |                                     |   |        |  
|                                                                                                                           |  |                                     
|Net loss attributable to common shareholders per sharebasic and diluted                                                   |  |                                      |        |   |                                     |   |        |  
|As reported                                                                                                                |  | $                                    | (0.15  | ) |                                     | $ | (0.19  | )
|Pro forma                                                                                                                  |  |                                      | (0.16  | ) |                                     |   | (0.23  | )

---

|(1) | See Note 3, to the Consolidated Financial Statements
|--- | ----------------------------------------------------

Our results for the
three- and nine- months ended September 30, 2005 included $9,100 of stock-based compensation related to the issuance of 2,806 shares of common stock, and $28,000 of stock-based compensation related to the issuance of 7,858 shares of common
stock to our board of directors members, respectively. During the three and nine months ended September 30, 2005 we recorded $2,000 and $6,000 of compensation expense in accordance with APB No. 25.

During the three- and nine- month periods ended September 30, 2005 we issued no shares and 7,624 shares common stock with a fair market value of $0 and $29,000 to
members of management in lieu of cash payment for a portion of their bonus accrued during 2004. This amount was excluded from the table above.

We utilized
the Black-Scholes valuation model for estimating the fair value of the stock compensation granted after the adoption of SFAS No. 123R. The weighted-average fair values of the options granted under the stock option plans were $1.16 and $1.67 for
the three- and nine- months ended September 30, 2006 as compared to $3.39 and $3.68 for the same periods in 2005, using the following assumptions:



15



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##### Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



|                                 |  |                                 |   |  |         |  
|-------------------------------- |  | ------------------------------- | - |  | ------- | -
|                                 |  | Nine Months Ended September 31, |  
|                                 |  | 2006                            |   |  | 2005    |  
|Average risk free interest rates |  | 4.78                            | % |  | 4.26    | %
|Expected dividend yield          |  | None                            |   |  | None    |  
|Expected life                    |  | 7 Years                         |   |  | 7 Years |  
|Expected volatility              |  | 130                             | % |  | 139     | %

The dividend yield of zero is based on the fact that we have never paid cash dividends and have no present
intention to pay cash dividends. Expected volatility is based on the historical volatility of our common stock over the period commensurate with or longer than the expected life of the options. The risk-free interest rate is based upon interpolation
of various U.S. Treasury rates on the date of grant. The expected life is based upon historical experience.

Based on our historical voluntary turnover
rates, an annualized estimated forfeiture rate of 6% has been used in calculating the recorded expense. Under the true-up provisions of SFAS No. 123R, additional expense will be recorded if the actual forfeiture rate is lower than estimated,
and a recovery of prior expense will be recorded if the actual forfeiture is higher than estimated. During the three months ended September 30, 2006 we experienced higher than anticipated forfeitures, and as a result a net reduction of
compensation was recorded for the period.

Changes in outstanding stock options for the three- and nine- months ended September 30, 2006, were as
follows:



|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|------------------------------------------------ |  | ---------------------- | - |  | ------------------------------ | ---- | ------------------------------------------------- | ---- | ------------------------------- | - | -----
|                                                 |  | Number of StockOptions |   |  | Weighted-AverageExercise Price |      | Weighted-AverageRemainingContractual Termin Years |      | AggregateIntrinsicValue($000s)
|Outstanding at December 31, 2005-As Restated (1) |  | 1,665,224              |   |  | $                              | 1.40 |                                                   |      |                                 |   |      
|Granted                                          |  | 330,000                |   |  |                                | 1.80 |                                                   |      |                                 |   |      
|Exercised                                        |  | (9,300                 | ) |  |                                | 0.58 |                                                   |      |                                 |   |      
|Forfeited                                        |  | (213,634               | ) |  |                                | 1.93 |                                                   |      |                                 |   |      
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|Outstanding at March 31, 2006                    |  | 1,772,290              |   |  | $                              | 1.42 |                                                   | 7.19 |                                 | $ | 1,922
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|Exercisable at March 31, 2006                    |  | 1,336,920              |   |  | $                              | 1.38 |                                                   | 6.50 |                                 | $ | 1,614
|Granted                                          |  | 6,500                  |   |  |                                | 2.25 |                                                   |      |                                 |   |      
|Exercised                                        |  | (20,834                | ) |  |                                | 0.72 |                                                   |      |                                 |   |      
|Forfeited                                        |  | (159,034               | ) |  |                                | 2.39 |                                                   |      |                                 |   |      
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|Outstanding at June 30, 2006                     |  | 1,598,922              |   |  | $                              | 1.34 |                                                   | 6.49 |                                 | $ | 674  
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|Exercisable at June 30, 2006                     |  | 1,163,558              |   |  | $                              | 1.26 |                                                   | 5.73 |                                 | $ | 619  
|Granted                                          |  | 5,000                  |   |  |                                | 1.25 |                                                   |      |                                 |   |      
|Exercised                                        |  | (54,734                | ) |  |                                | 0.37 |                                                   |      |                                 |   |      
|Forfeited                                        |  | (319,065               | ) |  |                                | 1.82 |                                                   |      |                                 |   |      
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|Outstanding at September 30, 2006                |  | 1,230,123              |   |  | $                              | 1.25 |                                                   | 5.56 |                                 | $ | 404  
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      
|Exercisable at September 30, 2006                |  | 1,161,969              |   |  | $                              | 1.26 |                                                   | 5.46 |                                 | $ | 396  
|                                                 |  |                        |   |  |                                |      |                                                   |      |                                 |   |      

---

|(1) | See Note 3, to the Consolidated Financial Statements
|--- | ----------------------------------------------------

As of
September 30, 2006, we had $49,000 of unrecognized compensation cost related to unvested awards, which we expects to recognize over a weighted-average period of 2 years.

The total intrinsic value of options exercised for the three-months ended September 30, 2006 and 2005 were $53,000 and $411,000, respectively. Total intrinsic value of options exercised for the nine-months ended
September 30, 2006 and 2005 were $106,000 and $493,000, respectively.



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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



7. Segment Reporting

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



|               |  |                                 |   |  |                                |   |  |      |   |  |                      |  
|-------------- |  | ------------------------------- | - |  | ------------------------------ | - |  | ---- | - |  | -------------------- | -
|               |  | Three Months EndedSeptember 30, |   |  | Nine Months EndedSeptember 30, |  
|               |  | 2006                            |   |  | 2005 As Restated (1)           |   |  | 2006 |   |  | 2005 As Restated (1) |  
|United States  |  | 52                              | % |  | 46                             | % |  | 51   | % |  | 49                   | %
|Sweden         |  | 9                               | % |  | 13                             | % |  | 8    | % |  | 11                   | %
|Asia           |  | 5                               | % |  | 7                              | % |  | 6    | % |  | 7                    | %
|Rest of Europe |  | 22                              | % |  | 20                             | % |  | 22   | % |  | 21                   | %
|Rest of World  |  | 12                              | % |  | 14                             | % |  | 13   | % |  | 12                   | %
|               |  |                                 |   |  |                                |   |  |      |   |  |                      |  
|Total          |  | 100                             | % |  | 100                            | % |  | 100  | % |  | 100                  | %

---

|(1) | See Note 3, to the Consolidated Financial Statements
|--- | ----------------------------------------------------

Revenues from one
customer represented 17% and 13% of total revenues for the three and nine months ended September 30, 2006. Revenue from one customer represented 11% for the three months ended and September 30, 2005 and two customers represented 23% of
total revenues for the nine months ended September 30, 2005.

The following table presents our long-lived assets, net of depreciation and
amortization, as of September 30, 2006 and December 31, 2005 (in thousands):



|              |  |                   |     |                  |   |    
|------------- |  | ----------------- | --- | ---------------- | - | ---
|              |  | September 30,2006 |     | December 31,2005
|United States |  | $                 | 538 |                  | $ | 527
|Europe        |  |                   | 46  |                  |   | 72 
|              |  |                   |     |                  |   |    
|Total         |  | $                 | 584 |                  | $ | 599

8. Restructuring

On August 6, 2006, we announced a restructuring plan intended to reduce costs and return the company to sustained profitability. The restructuring plan, which involves a reduction in workforce and consolidation of offices, is being
implemented in response to our recent operating losses and our renewed focus on core products and services. We reduced our workforce by 15 employees, or approximately 20 percent of our regular full-time staff, and initiated the closing of two sales
offices. The reduction in workforce happened in the third and fourth quarter of 2006 and the second quarter of 2007. We expect the office closures to occur by the end of 2007. These workforce reductions are in addition to the management changes
previously announced by Gensym on July 27 and August 6, 2006.

We incurred charges relating to the restructuring plan of approximately $544,000,
the majority of which related to employee severance payments. All of these charges will result in cash expenditure, of which $112,000 was incurred in the quarter ending September 30, 2006, $196,000 was incurred in the quarter ended
December 31, 2006 and the remainder will be incurred in the second quarter of 2007.



17



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##### Table of Contents

|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

Forward-Looking Statements

This Quarterly Report on Form 10-Q 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 in this Quarterly Report, words such as anticipate, believe, estimate, expect, intend and similar expressions, as they relate to
our management or us, 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
in Item 1A of Part II under the caption Risk Factors. Should one or more of these risks or uncertainties materialize, or should an 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.

Restatement of previously issued financial statements

The following discussion and analysis gives effect to the restatement described in Note 3 to the Consolidated Financial Statements in Part I, Item 1 of this
quarterly report. For this reason, the data set forth in this section may not be comparable to discussions in our previously filed annual and quarterly reports.

Business Overview

We are a provider of rule engine software and services for mission-critical solutions that support and automate decisions
in real time. Our flagship G2 software applies real-time rule technology to information in order to optimize operations and detect, diagnose and resolve costly problems. With applications based on G2, organizations in manufacturing, utilities,
communications, transportation, aerospace, finance and government increase the agility of their business operations and achieve greater levels of performance.

Our products apply rule-logic in real time to enable organizations to make better operational decisions. Benefits derived from the use of our products include:



| |  |  | greater agility in responding to changing business conditions;
| | - |  | --------------------------------------------------------------



| |  |  | increased production capacities;
| | - |  | --------------------------------



| |  |  | reduced consumption of energy, materials and resources;
| | - |  | -------------------------------------------------------



| |  |  | avoidance of capital expenditures;
| | - |  | ----------------------------------



| |  |  | waste reduction;
| | - |  | ----------------



| |  |  | higher levels of product and service quality; and
| | - |  | -------------------------------------------------



| |  |  | avoidance of costly operational disruptions and shutdowns.
| | - |  | ----------------------------------------------------------

Our key product is G2, a mature and robust software platform that underlies all of our other products. We released our most recent version of G2, version 8.2, in December 2005. The version 8.2 release represents another significant advance
in our next generation of G2, where we have been investing heavily since 2002. Version 8.2 of G2 delivers a comprehensive and unified foundation for a wide range of reasoning-driven products and solutions available from us and our partners. The
release offers a unified framework of reasoning building blocks including natural language rules, procedures, object modeling, simulation, business process and workflow execution, graphical diagnostics, message handling, data processing,
integration, Web technology and many developer productivity tools. The release also expands G2s capabilities for business process and workflow execution, rules, integration and user interface.

We offer a number of products that use G2 as a platform. These products enable customers to implement certain types of applications more quickly and economically by
providing domain-specific functionality.

Our current products are:



|                |  |                                                                                                                             
|--------------- |  | ----------------------------------------------------------------------------------------------------------------------------
|Product         |  | Application                                                                                                                 
|G2©             |  | Real-time, rule engine platform for optimizing operations and detecting, diagnosing and responding to problems in real time.
|                | 
|G2 NeurOn-Line |  | Online, rule-driven neural-network models that predict, control and optimize complex non-linear processes.                  
|                | 
|G2 Optegrity©   |  | Abnormal condition management for process manufacturing plants.                                                             
|                | 
|G2 Integrity   |  | Expert fault management of voice and data networks.                                                                         
|                | 
|G2 ReThink®     |  | Management of the business process life cycle through rule-driven simulation and online automation.                         
|                | 
|G2 e-SCOR       |  | Simulation and analysis of supply-chain designs, policies and practices.                                                    



18



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##### Table of Contents

We have a professional services group that can be engaged by our customers to develop applications or to assist in the
development of applications. However, many of our customers, particularly our partners, build their own applications. We also offer courses to train customers in the use of our products.

We derive revenue from sales of and service for our products and account for such revenue in four ways:



| |  |  | Sale of product licensesmostly one-time payment for perpetual licenses.
| | - |  | ------------------------------------------------------------------------



| |  |  | Customer support servicesincludes both product support and product enhancements and updates. Pricing is generally based on a percentage of the price of
the product license. Service contracts, mandatory for the first year following the purchase of a product license, are typically for one-year periods. Payment is due at the commencement of each support year, but revenue is recognized over the course
of the year.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Consulting servicesvarious billable services to customers for helping develop and install applications. Most of these services are billed on a time and
materials basis. Occasionally, we enter into fixed price arrangements, which are usually accounted for using a proportional performance model.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Educational servicestraining in the use of our products, some in public classes and some in-house for customers who require a dedicated training
program. These services are billed on a course-fee or day-rate basis.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We have a sales force in the United States, Europe and the Middle
East. Our sales force is focused on the generation of new business in several vertical and horizontal markets. The vertical markets include: chemical, oil and gas; other process manufacturing; discrete manufacturing; power utilities; water
utilities; telecommunications; government; transportation; and aerospace. The horizontal markets include business process management, supply chain management, and modeling and simulation.

Our sales activities have historically involved a combination of direct sales to end users and indirect sales through partners. We have an indirect channel strategy for
our sales force that places its primary focus on development of new business through indirect channels. In addition, our sales force supports the current and future needs of our existing end user customers. As part of the execution of our indirect
channel strategy, we have introduced new indirect channel programs designed to improve our ability to attract new partners and to support existing partners, who pursue business based on our products across our target vertical markets. Channel
partners are also able to provide development, support and training services to our customers. We have channel partners in North and South America, Europe, the Middle East, Africa and the Asian-Pacific region.

The following is the breakdown of revenue by product and service revenue:



|                                    |  |                                |   |  |                               |   |  |      |   |  |                      |  
|----------------------------------- |  | ------------------------------ | - |  | ----------------------------- | - |  | ---- | - |  | -------------------- | -
|                                    |  | Three Month EndedSeptember 30, |   |  | Nine Month EndedSeptember 30, |  
|                                    |  | 2006                           |   |  | 2005 As Restated (1)          |   |  | 2006 |   |  | 2005 As Restated (1) |  
|Product license sales               |  | 23                             | % |  | 26                            | % |  | 34   | % |  | 35                   | %
|Consulting and educational services |  | 37                             | % |  | 20                            | % |  | 26   | % |  | 23                   | %
|Customer support services           |  | 40                             | % |  | 54                            | % |  | 40   | % |  | 42                   | %
|                                    |  |                                |   |  |                               |   |  |      |   |  |                      |  
|                                    |  | 100                            | % |  | 100                           | % |  | 100  | % |  | 100                  | %
|                                    |  |                                |   |  |                               |   |  |      |   |  |                      |  

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

Prices for our products are generally denominated in U.S. dollars or Euros. Telecommunications, the U.S. Government, particularly the Department of Defense and Department of Energy, manufacturing, transportation, and
the chemical, oil and gas industries are major markets for us. We have several significant OEM partners, including Siemens, Ericsson, and Motorola.



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##### Table of Contents

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, 2005. During the nine-month period ended September 30, 2006 we adopted Statement of Financial Standard No. 123 (Revised 2004), Share-Based Payment, (SFAS No. 123R) which fully explained in footnote 6 to the
financial statements.

Results of Operations

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



|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|-------------------------------------- |  | ------------------------------- | -- |  | ------------------------------ | -- |  | ---- | -- |  | ------------------- | --
|                                       |  | Three Months EndedSeptember 30, |    |  | Nine Months EndedSeptember 30, |   
|                                       |  | 2006                            |    |  | As Restated (1)2005            |    |  | 2006 |    |  | As Restated (1)2005 |   
|Revenues:                              |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Product                                |  | 23                              | %  |  | 26                             | %  |  | 34   | %  |  | 35                  | % 
|Services                               |  | 77                              | %  |  | 74                             | %  |  | 66   | %  |  | 65                  | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Total Revenues                         |  | 100                             | %  |  | 100                            | %  |  | 100  | %  |  | 100                 | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|                                       |  |                                 |    | 
|Cost of revenues:                      |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Product                                |  | 3                               | %  |  | 4                              | %  |  | 3    | %  |  | 3                   | % 
|Services                               |  | 32                              | %  |  | 32                             | %  |  | 27   | %  |  | 27                  | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Total Cost of Revenues                 |  | 34                              | %  |  | 36                             | %  |  | 30   | %  |  | 30                  | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|                                       |  |                                 |    | 
|Gross Profit                           |  | 66                              | %  |  | 64                             | %  |  | 70   | %  |  | 70                  | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|                                       |  |                                 |    | 
|Operating Expenses:                    |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Sales and Marketing                    |  | 22                              | %  |  | 36                             | %  |  | 27   | %  |  | 31                  | % 
|Research and Development               |  | 16                              | %  |  | 31                             | %  |  | 19   | %  |  | 24                  | % 
|General & Administrative               |  | 26                              | %  |  | 31                             | %  |  | 27   | %  |  | 25                  | % 
|Restructuring                          |  | 12                              | %  |  |                               | %  |  | 4    | %  |  |                    | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Total Operating Expenses               |  | 76                              | %  |  | 98                             | %  |  | 77   | %  |  | 80                  | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|                                       |  |                                 |    | 
|Operating loss                         |  | (10                             | )% |  | (34                            | )% |  | (7   | )% |  | (10                 | )%
|                                       |  |                                 |    | 
|Other expense, net                     |  |                                | %  |  | (2                             | )% |  |     | %  |  | (1                  | )%
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|                                       |  |                                 |    | 
|Loss before provision for income taxes |  | (10                             | )% |  | (36                            | )% |  | (7   | )% |  | (11                 | )%
|Provision for income taxes             |  |                                | %  |  |                               | %  |  |     | %  |  |                    | % 
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   
|Net loss                               |  | (10                             | )% |  | (36                            | )% |  | (7   | )% |  | (11                 | )%
|                                       |  |                                 |    |  |                                |    |  |      |    |  |                     |   

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

Revenues

We derive revenue from two sources: product and services. Product revenues include revenues from sales of
licenses for use of our software products which include G2 and related application software. 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.



20



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##### Table of Contents

We derive revenues from U.S. and international customers. Revenues for the three- and nine- month periods ended
September 30, 2006 and 2005 were as follows:



|               |  |                                  |       |  |                                 |   |  |      |       |  |                     |   |  |   |        |  |    |   |  |   |        |  |    |  
|-------------- |  | -------------------------------- | ----- |  | ------------------------------- | - |  | ---- | ----- |  | ------------------- | - |  | - | ------ |  | -- | - |  | - | ------ |  | -- | -
|               |  | Three Months Ended September 30, |       |  | Nine Months Ended September 30, |  
|               |  | 2006                             |       |  | 2005As Restated (1)             |   |  | 2006 |       |  | 2005 AsRestated (1) |  
|U.S.           |  | $                                | 2,293 |  | 52                              | % |  | $    | 1,436 |  | 46                  | % |  | $ | 6,482  |  | 51 | % |  | $ | 6,110  |  | 49 | %
|International  |  |                                  | 2,090 |  | 48                              | % |  |      | 1,700 |  | 54                  | % |  |   | 6,241  |  | 49 | % |  |   | 6,391  |  | 51 | %
|               |  |                                  |       |  |                                 |   |  |      |       |  |                     |   |  |   |        |  |    |   |  |   |        |  |    |  
|Total Revenues |  | $                                | 4,383 |  |                                 |   |  | $    | 3,136 |  |                     |   |  | $ | 12,723 |  |    |   |  | $ | 12,501 |  |    |  

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

The overall increase in revenue of $1.2 million or 40% between the three-months ended September 30, 2006 and the same period in 2005 was primarily the result of a large government project in 2006 and an increase
in overall European consulting projects. The overall increase in revenue of $0.2 million or 2% between the nine-months ended September 30, 2006 and the same period in 2005 was primarily the result of an increase in overall consulting projects.

The overall increase of $0.9 million in U.S. revenues was primarily the result of an increase in service revenues between the three-months ended
September 30, 2006 and the same period in 2005 based on the receipt of a large government contract in 2006 that we did not receive in 2005. The overall increase of $0.3 million in international revenues was primarily the result of an increase
in general consulting service revenues between the nine-months ended September 30, 2006 and the same period in 2005.

Our worldwide product and
service revenues for the three-month periods ended September 30, 2006 and 2005 were as follows:



|               |  |                             |       |                            |   |       |  |                     |        |  |   |       
|-------------- |  | --------------------------- | ----- | -------------------------- | - | ----- |  | ------------------- | ------ |  | - | ------
|               |  | Three Months EndedSeptember |       | Nine Months EndedSeptember
|               |  | 2006                        |       | 2005As Restated (1)        |   | 2006  |  | 2005As Restated (1)
|Revenues:      |  |                             |       |                            |   |       |  |                     |        |  |   |       
|Product        |  | $                           | 1,006 |                            | $ | 811   |  | $                   | 4,326  |  | $ | 4,416 
|Services       |  |                             | 3,377 |                            |   | 2,325 |  |                     | 8,397  |  |   | 8,085 
|               |  |                             |       |                            |   |       |  |                     |        |  |   |       
|Total Revenues |  | $                           | 4,383 |                            | $ | 3,136 |  | $                   | 12,723 |  | $ | 12,501

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

Product revenues for the three months ended September 30, 2006 increased by $0.2 million, or 24%, as compared to the same period in 2005 due to an increase in license bookings. Product revenues for the nine
months ended September 30, 2006 decreased by $0.1 million, or 2%, as compared to the same period in 2005 due to a reduction in license bookings.

Services revenues for the three months ended September 30, 2006 increased $1.1 million, or 45%, as compared to the same period in 2005. This increase was mainly attributable to the receipt of a large government order in 2006 that we
did not receive in 2005 and an increase in general European consulting projects. Services revenues for the nine months ended September 30, 2006 increased $0.3 million, or 4%, as compared to the same period in 2005. This increase was mainly
attributable to the receipt of a large government order in 2006 that we did not receive in 2005 and an increase in general European consulting projects offset by a reduction in software support contracts.

Revenues from one customer represented 17% and 13% of total revenues for the three and nine months ended September 30, 2006. Revenue from one customer represented
11% for the three months ended and September 30, 2005 and two customers represented 23% of total revenues for the nine months ended September 30, 2005.



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##### Table of Contents

Cost of Revenues

Cost of revenues primarily consist of consulting labor, technical support costs, and the costs of material and labor involved in producing and distributing our software. These costs for the three- and nine- month
periods ended September 30, 2006 and 2005 were as follows:



|                       |  |                             |       |                            |   |       |  |                     |       |  |   |      
|---------------------- |  | --------------------------- | ----- | -------------------------- | - | ----- |  | ------------------- | ----- |  | - | -----
|                       |  | Three Months EndedSeptember |       | Nine Months EndedSeptember
|                       |  | 2006                        |       | 2005As Restated (1)        |   | 2006  |  | 2005As Restated (1)
|Cost of Revenues:      |  |                             |       |                            |   |       |  |                     |       |  |   |      
|Product                |  | $                           | 112   |                            | $ | 115   |  | $                   | 339   |  | $ | 370  
|Services               |  |                             | 1,387 |                            |   | 995   |  |                     | 3,485 |  |   | 3,427
|                       |  |                             |       |                            |   |       |  |                     |       |  |   |      
|Total Cost of Revenues |  | $                           | 1,499 |                            | $ | 1,110 |  | $                   | 3,824 |  | $ | 3,797

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

Product costs remained relatively consistent for the three- and nine- months ended September 30, 2006 as compared to the same periods in 2005 because production costs are generally fixed and do not fluctuate in
proportion to a change in license sales.

Service costs increased $0.4 million, or 39%, for the three months ended September 30, 2006 as compared to
the same period in 2005. This increase was primarily attributable to a $0.3 million increase in labor costs associated with new employees and contractors used, $0.1 million of costs associated with the recognition of costs previously in Work in
Progress related to a project that met a milestone for revenue recognition during the period, $0.06 million in pass through costs associated with the large government contract, $0.05 million of labor usually allocated to sales, but not allocated in
this period as consultants were working on billable projects instead of sales support, and $0.03 million in additional commissions based on increased sales. Service costs increased $0.1 million, or 2%, for the nine months ended September 30,
2006 as compared to the same period in 2005. This increase was primarily attributable to a $0.3 million increase in labor costs associated with new employees, $0.1 million of costs associated with the recognition of costs previously in Work in
Progress related to a project that met a milestone for revenue recognition during the period, $0.05 million in pass through costs associated with the large government contract, $0.04 million of labor not allocated to sales as consultants were
working on billable projects,, and $0.03 million in additional commissions based on increased sales, offset by a decrease of $0.4 million of outside consultants not needed in 2006 to perform services under consulting projects.

Gross margin percentages for the three- and nine-month periods ended September 30, 2006 and 2005 were as follows:



|                   |  |                             |   |  |                            |   |  |      |   |  |                     |  
|------------------ |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ------------------- | -
|                   |  | Three Months EndedSeptember |   |  | Nine Months EndedSeptember |  
|                   |  | 2006                        |   |  | 2005As Restated (1)        |   |  | 2006 |   |  | 2005As Restated (1) |  
|Gross margins:     |  |                             |   |  |                            |   |  |      |   |  |                     |  
|Product            |  | 89                          | % |  | 86                         | % |  | 92   | % |  | 92                  | %
|Services           |  | 59                          | % |  | 57                         | % |  | 58   | % |  | 58                  | %
|                   |  |                             |   |  |                            |   |  |      |   |  |                     |  
|Total Gross Margin |  | 66                          | % |  | 65                         | % |  | 70   | % |  | 70                  | %

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

Our gross margin on product increased from 86% to 89% during the three-month period ended September 30, 2006 as compared to the same period in 2005 and remained relatively unchanged for the nine-month period
ended September 30, 2006 as compared to the same period in 2005. Our product expenses are relatively low and consistent as they generally consist of fixed labor and facility costs, therefore, the gross margin remains consistent unless there is
a significant change in license revenue.

Our gross margin on service increased from 57% to 59% and 58% to 59% for the three- and nine-month periods ended
September 30, 2006 as compared to the same period in 2005. These increases were a result of using employees to perform services versus outside contractors.



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##### Table of Contents

Operating Expenses



|                           |  |                             |       |                            |   |       |  |                    |       |  |   |      
|-------------------------- |  | --------------------------- | ----- | -------------------------- | - | ----- |  | ------------------ | ----- |  | - | -----
|                           |  | Three Months EndedSeptember |       | Nine Months EndedSeptember
|                           |  | 2006                        |       | 2005As Restated(1)         |   | 2006  |  | 2005As Restated(1)
|Operating expense:         |  |                             |       |                            |   |       |  |                    |       |  |   |      
|Sales and marketing        |  | $                           | 974   |                            | $ | 1,142 |  | $                  | 3,391 |  | $ | 3,851
|Research and development   |  |                             | 701   |                            |   | 970   |  |                    | 2,401 |  |   | 2,988
|General and administrative |  |                             | 1,123 |                            |   | 981   |  |                    | 3,416 |  |   | 3,145
|Restructuring              |  |                             | 544   |                            |   |      |  |                    | 544   |  |   |     
|                           |  |                             |       |                            |   |       |  |                    |       |  |   |      
|Total operating expense    |  | $                           | 3,342 |                            | $ | 3,093 |  | $                  | 9,752 |  | $ | 9,984

---

|(1) | See Note 3, to the Consolidated Financial Statements included in Part I, Item 1
|--- | -------------------------------------------------------------------------------

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 September 30, 2006 were $1.0 million, a decrease of $0.2 million, or 15%, as compared to the same period in 2005. The decrease was
primarily attributable to a $0.1 decrease in marketing programs based on cost reduction programs, a $0.05 million decrease in allocation from consulting services in support of sales, a $0.04 million decrease in recruiting and relocation expense, and
a $0.03 million reduction in facility expense as a result of the consolidation of our headquarters. These expenses for the nine-month period ended September 30, 2006 were $3.4 million, a decrease of $0.5 million, or 12%, as compared to the same
period in 2005. The decrease was primarily the result of a $0.2 million reduction in commission based on fewer sales people and new, lower paying commission plans, a $0.1 million decrease in personnel cost based on fewer people, a $0.1 million
decrease in facility cost due to fewer people and the result of consolidation of our headquarters, a $0.1 million decrease in marketing programs, a $0.05 decrease in relocation and recruiting expense and a $0.03 decrease in travel expense based on
cost reduction programs.

Research and Development. Research and development expenses consist primarily of costs of personnel, equipment and
facilities. Expenditures include research and support of the existing G2 product line and, in the three- and nine- months ended September 30, 2005 included the development of the software reasoning platform, TrueManage that was not continued in
2006. Total research and development expenses for the three months ended September 30, 2006 were $0.7 million, a decrease of $0.3 million or 28% from the comparable period in 2005. This decrease is primarily due to a $0.2 million decrease in
personnel and contractors for the TrueManage program, and a $0.1 million decrease in facility cost due to a reduction of personnel and as a result of consolidation of our headquarters. Total research and development expenses for the nine months
ended September 30, 2006 were $2.4 million, a decrease of $0.6 million or 20% from the comparable period in 2005. This decrease is primarily the result of $0.4 million decrease in personnel for the TrueManage program, and a $0.1 million
decrease in facility cost due to less people and the result of consolidation of our headquarters.

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 months ended September 30, 2006 increased $0.1
million or 14% as compared to the same period in 2005. This increase was a result of a one time $0.2 million severance charge related to the departure of our CEO, a $0.1 million increase in legal expenses associated with the restatement, a $0.1
million increase in accounting expense associated with the restatement, a $0.04 million increase in bad debt reserve as a result of a reserve reduction in 2005 that was not repeated in 2006, offset by a decrease in personal expense of $0.1 million,
a $0.1 million decrease in stock-based compensation expense associated with the departure of our CEO, a $0.1 million decrease in insurance expense for a claim made in 2005 that was not repeated in 2006, and a $0.05 million decrease in facility costs
attributable to the consolidation of our headquarters. The expense for the nine months ended September 30, 2006 increased $0.3 million or 9% from the comparable period in 2005. This was primarily the result of a $0.4 million increase in legal
expense associated with corporate planning and the restatement, a $0.1 million increase in accounting expense associated with the restatement, a one time $0.2 million severance charge related to the departure of our CEO, a $0.2 million decrease in
personnel expense, a $0.1 million increase in stock-based compensation expense associated with our adoption of SFAS 123(R) during 2006, a $0.05 million increase in bad debt expenses as a result of a bad debt reduction in 2005 not repeated in 2006, a
$0.05 million increase in professional service fees in support of the restatement, offset by a $0.1 million decrease in insurance expense for a claim made in 2005 that was not repeated in 2006, a $0.1 million decrease in facility costs attributable
to the consolidation of our headquarters, a $0.1 million termination settlement in 2005 that was not repeated in 2006, and a $0.05 decrease in travel expense as a result of a cost reduction program.



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##### Table of Contents

Restructuring. On August 6, 2006, we announced a restructuring plan intended to reduce costs and return the
company to sustained profitability. The restructuring plan, which involved a reduction in workforce and consolidation of offices, is being implemented in response to our recent operating losses and our renewed focus on core products and services.
The plan reduces our workforce by 15 employees, or approximately 20 percent of its regular full-time staff, and closes two sales offices. These expenses for the three- and nine- month period ended September 2006 were $0.5 million. We did not have
restructuring expenses in 2005. The majority of the expenses relate to employee severance payments. All of these charges will result in cash expenditures, of which approximately $0.2 million were incurred in the quarter ending September 30,
2006 and the remainder will be incurred in the fourth quarter of 2006 and the second quarter of 2007.

Other Income, Expense

Other income, net for the three- and nine- months ended September 30, 2006 was $1,000 and $26,000, compared to other expense, net of $67,000 and
$89,000 for the same periods in 2005. The decrease is primarily due to foreign exchange rate fluctuations.

Income Taxes

Our provision for income taxes results from anticipated income tax credits in the U.S. based on operating loss carry forwards offset by tax liabilities in foreign
jurisdictions where our wholly owned subsidiaries have taxable income but may not have operating loss carry forwards to reduce tax obligations. Provision for income taxes for the three- and nine- months ended September 30, 2006 was $7,000 and
$16,000 compared to reduction in provision of $18,000 and a provision of $6,000 for the same periods in 2005. The increase in the tax expense for both periods is a result of a reduction in tax obligation in 2005 based on our tax filing not repeated
in 2006.

LIQUIDITY AND CAPITAL RESOURCES

Our
September 30, 2006 cash and cash equivalents were $3.3 million, an increase of $0.1 million from December 31, 2005.

For the nine months ended
September 30, 2006, we had $0.4 million provided by operating activities offset by $0.2 million used in investing activities and $40,000 used in financing activities.

We reported $0.4 million and $0.1 million of cash flow from operations for the nine months ended September 30, 2006 and 2005, respectively. The difference was primarily a result of $0.5 million of higher profits
offset by $0.1 million of lower prepaids and other assets as we recognized expenses paid in a previous period, $1.1 million decrease in deferred revenue as previously paid contracts became recognized revenue, $0.5 million decrease in collections
from accounts receivable and a decrease in operating cash outflows of $1.0 million as accrued expenses increased.

Cash flows used in investing activities
were $0.2 million for the nine-month period ended September 30, 2006 as compared to cash provided by investing activities of $0.1 million for the nine-month period ended September 30, 2005. Cash used were primarily used for purchases of
property and equipment offset by a $0.4 million return of a security deposit for our headquarters facility.

Cash flows used in financing activities were
$40,000 for the nine-month period ended September 30, 2006 as compared to cash provided by financing activities of $0.1 million for the nine-month period ended September 30, 2005. These were primarily used for principal payments on capital
lease obligations offset by cash received for the exercise of stock options.

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 equipment.

Managements expectations for future revenue growth, profitability, and operating cash flows involve significant judgments and estimates. Should these judgments and
estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure that we maintain positive cash and working capital. Any of these actions could have
a material adverse long-term effect on our business, financial condition and results of operations.



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##### Table of Contents

Commitments and Contingencies

Leases

We lease our facilities and certain equipment under operating and capital leases. The future minimum annual
payments under these leases at September 30, 2006 are as follows:



|                                              |  |                 |       |               |   |    
|--------------------------------------------- |  | --------------- | ----- | ------------- | - | ---
|                                              |  | (in thousands) 
|For the period ended December 31,             |  | OperatingLeases |       | CapitalLeases
|2006                                          |  | $               | 158   |               |   | 30 
|2007                                          |  |                 | 580   |               |   | 110
|2008                                          |  |                 | 445   |               |   | 22 
|2009                                          |  |                 | 405   |               |   | 8  
|2010                                          |  |                 | 394   |               |   | 1  
|Thereafter                                    |  |                 | 110   |               |   |   
|                                              |  |                 |       |               |   |    
|Total minimum lease payments                  |  | $               | 2,092 |               | $ | 171
|Less: Amount representing interest            |  |                 |       |               |   | 13 
|                                              |  |                 |       |               |   |    
|Present value of minimum lease payments       |  |                 |       |               |   | 158
|Less: Current portion                         |  |                 |       |               |   | 110
|                                              |  |                 |       |               |   |    
|Long-term portion of capital lease obligation |  |                 |       |               | $ | 48 

Litigation

We are involved in various lawsuits, claims and inquiries, most of which are routine to the nature of our business. In the opinion of our management, the resolution of these matters will not have a material adverse
effect on our financial position, results of operations or cash flows.

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 September 30, 2006, 501,300 shares
had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2006, 2005 or 2004. During the three months ended September 30, 2006 and 2005, respectively, we reissued 0 and 2,806 shares of common stock to employees and
non-employee directors. As of September 30, 2006, 332,369 shares remained in treasury at a cost of $1,239,736.

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 three employees who continue to work for us. In March 2005, July 2005, June 2006 and April 2007 we extended the agreement for additional increments. The contract expired on February 13, 2007. On February 15,
2007 we signed a new one-year Original Equipment Manufacturer agreement which will expire on February 14, 2008. Both agreements call 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. In April 2007 we terminated one of the employees involved with Integration Objects and determined that the other two
employees were no longer associated with Integration Objects. During the three- and nine- month periods ended September 30, 2006, we paid Integration Objects a total of $12,296 and $40,464 respectively. At September 30, 2006 we had unpaid
royalties of $28,232 due to Integration Objects, Inc.

On April 21, 2005 we entered into a six month consulting agreement with Cianciotta Holdings,
Inc., an entity wholly-owned by Frank Cianciotta, who was then a member of our board of directors. Pursuant to the agreement, Cianciotta Holdings, Inc. provided business development and sales consulting services to us, which services were performed
by Mr. Cianciotta. The agreement called for payments of $6,500 per month to assist in strategic business development opportunities. In September 2005, we entered into a consulting agreement with Market Partners, Inc., a provider of consulting
and technology solutions. Pursuant to the agreement, Market Partners, Inc. provided business development and sales consulting services to us, which services were provided by Mr. Cianciotta who was a subcontractor for Market Partners, Inc. We
agreed to pay Market Partners, Inc. $10,000 per month for consulting services and an additional $3,333 per month for the first six months of the agreement as a performance bonus. After the first six months, the monthly performance bonus payment
under the agreement was to be an amount equal to 5% of our gross revenue for web hosted business or software delivered on a monthly service fee basis. We terminated the agreement with Market Partners, Inc. effective March 1, 2006.
Mr. Cianciotta resigned from our



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board of directors effective October 27, 2005. We paid Mr. Cianciotta or Market Partners, Inc. a total of $44,686 for the three months ending
September 30, 2006 pursuant to these consulting agreements. At September 30, 2006 we had no unpaid consulting fees owed to Mr. Cianciotta or Market Partners, Inc.

New Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements, which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS No. 157 establishes a common definition of fair value, provides a framework for measuring fair value under U.S. generally
accepted accounting principles and expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for financial statements issued in fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. The Company is currently evaluating the impact, if any, the adoption of SFAS No. 157 will have on the consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (SAB 108), which expresses the Staffs views regarding the process of quantifying financial statement misstatements. The bulletin was
effective at fiscal year end 2006. The implementation of this bulletin had no impact on the Companys results of operations, cash flows or financial position.

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No.48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109(FIN 48). FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in an entitys financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position
taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning
after December 15, 2006, with early adoption permitted. We will adopt FIN 48 on January 1, 2007. We are currently evaluating the impact that the adoption of FIN 48 will have on our consolidated financial statements.



|ITEM 3. | Quantitative and Qualitative 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 September 30, 2006,
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. We transact business in various countries and thus have exposure to adverse movements in
foreign currency exchange rates. This exposure is primarily related to intercompany receivable and payable balances that are recorded on the balance sheet in currencies other than the functional currency. These amounts are translated at each month
end to the functional currency in each country, and any resulting gain or loss is recorded in the currency translation adjustment of the equity section of the balance sheet. In addition, we have certain cash balances held in currencies other than
our functional currency or the functional currency of our subsidiaries. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the appropriate statements of
operations.



|ITEM 4. | Controls and Procedures.
|------- | ------------------------

Our management, with the participation of
our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2006. The term disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the SECs rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be
disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the companys management, including its principal executive and principal financial officers, as appropriate to allow
timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their



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objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the
evaluation of our disclosure controls and procedures as of September 30, 2006, as a result of the material weaknesses in our internal controls over financial reporting described below, our chief executive officer and chief financial officer
concluded that, as of such date, our disclosure controls and procedures were not effective.

In July 2006, we announced that our Audit Committee had
undertaken a detailed investigation of the revenue recognition accounting for software license and service agreement transactions entered into during fiscal 2004 and 2005. In November 2006, we expanded the investigation to include software license
and services agreements entered into from 2000 to 2004. We also began a self-initiated review of historical stock option grant practices and related accounting treatment. The investigation and review were conducted with the assistance of outside
legal counsel and outside accounting specialists. Based on the investigation and review, management and the Audit Committee concluded that errors in revenue recognition, which primarily result in the deferral of revenue into later periods than
originally recognized, stock compensation and other accounting adjustments required us to restate previously reported financial results. The restatement effected previously reported results from 2000 through the first quarter of 2006.

In connection with the restatement, we assessed the effectiveness of our internal control over financial reporting. We and our independent registered public accounting
firm, Vitale, Caturano & Company, Ltd., identified and reported to our Audit Committee material weaknesses in our internal control over financial reporting identified in connection with the audit of our financial statements for the quarter
ended September 30, 2006. These material weaknesses include entity-level control weaknesses as well as weaknesses in process and transaction controls as defined in the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
criteria.

The following material weaknesses collectively resulted in us prematurely recognizing revenue, thereby causing revenue to be overstated in an
earlier period and understated in a later period, deferred revenue to be understated in any period, costs and expenses to vary in any particular period and our net loss to be understated in an earlier period and overstated in a later period. As a
consequence, we have restated our historical financial statements, as described elsewhere in this Quarterly Report on Form 10-Q, resulting in a reduction in revenue in the quarter ended September 30, 2005 of $69,000 and in an increase in net
loss in the quarter ended September 30, 2005 of $77,000.

We identified the following material weaknesses in connection with the audit of our
financial statements for the quarter ended September 30, 2006:



| |  |  | inappropriate level of responsibility for contract review and approval, as well as revenue recognition decisions;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | insufficient flow of documentation and information between operations and finance personnel;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | inappropriate responsibility of vice president of operations in overseeing the performance of the sales force and approving contracts;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | insufficient review of contracts by the operations personnel to ensure proper data entry of standard and non-standard terms;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | insufficient tracking of the issuance and return of license key codes;
| | - |  | ----------------------------------------------------------------------



| |  |  | insufficient tracking of inventory maintained by resellers; and
| | - |  | ---------------------------------------------------------------



| |  |  | insufficient processes for approving, issuing, documenting and accounting for stock option grants.
| | - |  | --------------------------------------------------------------------------------------------------

Beginning in the quarter ended June 30, 2006 we took a number of corrective actions to address the material weaknesses discussed above, including:



| |  |  | implementing enhanced accounting policies and internal controls, as well as improved sales policies and procedures, relating to sales, license delivery, consulting
management and product exchanges and returns;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | developing and implementing internal controls and compliance training programs for sales, operations and finance;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | implementing personnel changes;
| | - |  | -------------------------------



| |  |  | establishing clear and concise corporate polices, practices and controls; and
| | - |  | -----------------------------------------------------------------------------



| |  |  | implementing formal and documented procedures for approving, issuing, documenting and accounting for stock option grants.
| | - |  | -------------------------------------------------------------------------------------------------------------------------



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In addition, we implemented changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) during the fiscal quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. These changes include:



| |  |  | implementation of multi-person review process of revenue packages including system generated reports, expanded documentation requirements and approval requirements
of the chief financial officer; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Formalization of ongoing reporting of contact status and issues to senior management, including the chief financial officer.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------

We note, however, that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues including instances of fraud, if any, have been detected. These inherent limitations
include the realities that judgments in decision-making can be faulty, and breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Over time, our control systems may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected and could be material and require a restatement of our financial statements.

PART II. OTHER INFORMATION



|ITEM 1. | Legal Proceedings
|------- | -----------------

We are involved in various lawsuits, claims and
inquiries, most of which are routine to the nature of our business. In the opinion of management, the resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flow.



|ITEM 1A. | Risk Factors
|-------- | ------------

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 management from time to time.

The restatement of our consolidated financial statements and the matters relating to the investigations by the Audit Committee and by the Special Committee of the
Board of Directors may result in additional litigation and governmental enforcement actions.

On July 19, 2006, we announced that our Audit
Committee had undertaken a detailed review of the revenue recognition accounting for software license and service agreement transactions entered into during fiscal 2004 and 2005. The Audit Committee notified our independent public accounting firm
and engaged its own legal advisors and forensic accountants to assist it with its investigation. Also in July 2006, our Audit Committee concluded, in consultant and upon the recommendation of management in consultation with and upon the
recommendation of management, that our previously issued financial statements included in our Annual Reports on Form 10-K for the fiscal years ended December 31, 2004 and 2005 and in our Quarterly Reports on Form 10-Q for the interim fiscal
periods ended March 31, June 30 and September 30, 2005 and March 31, 2006, and all of our earnings releases and similar communications relating to those fiscal periods, should no longer be relied upon.

We conducted a review and investigation of several accounting issues with the assistance of outside legal counsel and outside accounting specialists. The review and
investigation included a review of our revenue recognition accounting for certain software license and service agreement transactions, stock option practices and related stock-based compensation expense and other accounting adjustments, including
foreign tax filing errors and accounting timing adjustments. These review and investigations, and related activities, have required us to incur substantial expenses for legal, accounting, tax and other professional services, and have diverted
managements attention from our business.

As a result of the review and investigation of our accounting practices, we restated previously released
financial statements for 2000 through the first quarter of 2006. We also recorded cumulative effect adjustments for fiscal years 2000



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through 2003, the effects of which are indicated as adjustments to our financial statements as of December 31, 2003. For more information on these
matters, see Managements Discussion and Analysis of Financial Condition and Results of Operations and Note 3 to our Consolidated Financial Statements.

While we believe we have made appropriate judgments in our reviews and resulting restatement as presented and described in this Quarterly Report on Form 10-Q, the SEC may disagree with the manner in which we have
accounted for and reported the financial impact. Accordingly, there is a risk we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.

We may also become the subject of, or otherwise required to incur legal fees and costs in connection with, private litigation, regulatory proceedings, or government
enforcement actions. No assurance can be given regarding the outcomes from such activities. The resolution of these matters will be time consuming, expensive, and will distract management from the conduct of our business. Our available
directors and officers liability insurance may not be sufficient to cover our legal expenses or those of persons we are obligated to indemnify. If we are subject to adverse findings in litigation, regulatory proceedings or government
enforcement actions, we could be required to pay damages or penalties or have other remedies imposed, which could have a material adverse effect on our business, financial condition, results of operations and cash flows. Furthermore, the
restatements of our financial results and any resulting litigation or SEC investigation could impact our relationships with customers and our ability to generate revenue.

We have identified material weaknesses in our disclosure controls and procedures and our internal control over financial reporting as of September 30, 2006 that, if not remedied effectively, could result in
material misstatements in our financial statements in future periods.

Our management is responsible for establishing and maintaining adequate internal
control over our financial reporting, as defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934, as amended. Our management assessed the effectiveness of our internal control over financial reporting as of
September 30, 2006, and identified material weaknesses. Our management also evaluated the effectiveness of our disclosure controls and procedures and, due to these material weaknesses, our disclosure controls and procedures were not effective
as of September 30, 2006.

A material weakness is defined as a control deficiency, or combination of significant control deficiencies, that results in
more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. A control deficiency exists when the design or operation of a control does not allow management or employees,
in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.

We identified the following material
weaknesses as of September 30, 2006:



| |  |  | inappropriate level of responsibility for contract review and approval, as well as revenue recognition decisions;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | insufficient flow of documentation and information between operations and finance personnel;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | inappropriate responsibility of vice president of operations in overseeing the performance of the sales force and approving contracts;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | insufficient review of contracts by the operations personnel to ensure proper data entry of standard and non-standard terms;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | insufficient tracking of the issuance and return of license key codes;
| | - |  | ----------------------------------------------------------------------



| |  |  | insufficient tracking of inventory maintained by resellers; and
| | - |  | ---------------------------------------------------------------



| |  |  | insufficient processes for approving, issuing, documenting and accounting for stock option grants.
| | - |  | --------------------------------------------------------------------------------------------------

For further information about these material weaknesses, please see Item 4  Controls and Procedures included elsewhere in this Quarterly Report on
Form 10-Q. Because of these material weaknesses, management concluded that, as of September 30, 2006, our internal control over financial reporting was not effective.

We have implemented and continue to implement a number of remedial measures designed to address the material weaknesses identified as of September 30, 2006. If these remedial initiatives are insufficient to
address the identified material weaknesses, or if additional material weaknesses or significant deficiencies in our internal control are discovered in the future, we may fail to meet our future reporting obligations on a timely basis, our financial
statements may contain material misstatements, our operating results may be harmed, we may fail to meet our future reporting obligations on a timely



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basis, we may be subject to litigation. Any failure to address the identified material weaknesses or any additional material weaknesses or significant
deficiencies in our internal control could also adversely affect the results of future management evaluations regarding the effectiveness of our internal control over financial reporting that are required under Section 404 of the
Sarbanes-Oxley Act of 2002. Internal control deficiencies could also cause investors to lose confidence in our reported financial information.

We can give
no assurance that the measures we have taken to date or any future measures we may take will remediate the material weaknesses identified or that any additional material weaknesses will not arise in the future due to a failure to implement and
maintain adequate internal control over financial reporting or circumvention of these controls. In addition, even if we are successful in strengthening our controls and procedures, those controls and procedures may not be adequate to prevent or
identify irregularities or facilitate the fair presentation of our financial statements or our periodic reports filed with the SEC.

Failure or
circumvention of our internal controls and procedures could seriously harm our business.

Our internal controls and procedures have been circumvented in
the past and may be circumvented in the future. We are making significant changes in our internal control over financial reporting and our disclosure controls and procedures. Any system of controls, however well designed and operated, is based in
part on certain assumptions and can provide only reasonable, and not absolute, assurances that the objectives of the system are met. The failure or circumvention of our controls, policies and procedures could have a material adverse effect on our
business, results of operations and financial condition.

Our financial statements have been impacted, and could be impacted again, by revenue
recognition errors.

We restated previously released financial statements for 2000 through the first quarter of 2006, which was in part due to revenue
recognition errors in the accounting for certain software license and service agreements. Our financial statements could be adversely impacted by improper or erroneous application of revenue recognition policies and accounting rules. For instance,
revenue recognition depends on, among other criteria, when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred (generally FOB shipping point or electronic distribution); (3) the fee is deemed fixed or
determinable; and (4) collection is probable. Our personnel may misrepresent an contract and consent to undocumented terms with a customer, imply delivery that has not occurred, make promises of future concessions or misrepresent a
customers credit rating. We have implemented policies and procedures we hope will prevent and discourage such improper application of revenue recognition policies and accounting rules, but there can be no assurance that such policies will be
followed. In addition, depending on when we learn of improper application of revenue recognition policies, we may have to restate our financial statements for a previously reported period, which would seriously harm our business, operating results
and financial condition.

We have a history of operating losses, and we may not be profitable.

We incurred operating losses in the three months ended September 30, 2006 and for three of the five years ended December 31, 2005. In August 2006 we announced a
strategic restructuring of our company in response to our recent losses and our renewed focus on core products and services that included a 20% reduction in workforce and the closing of two sales offices. We were profitable for the second quarter of
2006 but had operating losses for this third quarter of 2006 and for the first quarter of 2006 that caused us to incur an operating loss for 2006. As of September 30, 2006, our accumulated deficit was $22.1 million. Our ability to achieve and
maintain profitability is dependent on continued revenues from new and existing customers and expense control. There can be no assurance that we will return to profitability and even if we achieve profitability, we cannot assure that we can sustain
profitability on a quarterly or annual basis.

If we are not current in our filings with the SEC, we will face several adverse consequences.

We are not current with our financial filings and until we are current and if we are unable to remain current in our financial filings, we will not be
able to have a registration statement under the Securities Act of 1933, covering a public offering of securities, declared effective by the SEC, and we will not be able to make offerings pursuant to existing registration statements or pursuant to
certain private placement rules of the SEC under Regulation D, to any purchasers not qualifying as accredited investors. These restrictions may impair our ability to raise funds in the public markets, should we desire to do
so, and to attract and retain key employees.



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We are reliant on fees from maintenance contracts and renewals. If we fail to retain our maintenance customers, our
revenues may be adversely affected.

We rely on maintenance contract renewals for a significant percentage of our revenues, as software maintenance fees
have represented 38%, 41% and 41% of our total revenues in the years ended December 31, 2005, 2004 and 2003, respectively. For the three- and six- months ended September 30, 2006, software maintenance fees represented 39% and 40% of our
total revenue. While a maintenance contract on our products is mandatory for the first year after purchase, subsequent renewals of the maintenance contract are at the discretion of our customers. Accordingly, our failure to retain maintenance
customers or a significant decline in the rate of maintenance contract renewals could have a material adverse effect on our business, results of operations, cash flows, and financial position.

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. Sales of our products by such channel partners represented 58%, 51% and 58% of our product revenues in years ended December 31, 2005, 2004 and 2003, respectively. Sales of our products by
channel partners represented 69% and 68% of our total sales for the three- and nine- months ended September 30, 2006. 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, cash flows and financial position. 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, cash flows, and financial position.

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, our ability to
continue to attract, integrate, train, motivate and retain new sales and marketing personnel, and our ability to manage sales and channel partners. 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, results of operations, cash flows, or financial position.

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 or annual basis in the future. Our sales cycle typically ranges from 6 to 12 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 large 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 results of operations and cash flows, which may impact our ability to continue as an independent concern.

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 offer rule engine capabilities or that perform certain functions of G2 for specific applications. In all of our markets, there is competition from point solutions, real-time and rule engine 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.



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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 increasingly reliant on indirect
channel partners, including original equipment manufacturers, value-added resellers, and systems integrators, to satisfy market requirements. A number of software companies offer products that compete in specific application areas addressed by these
partners, such as cement kiln control, manufacturing execution systems, logistics systems, and network management, and they could be successful in supplying alternatives to products based on our software.

Companies offering competitive rule engine products include Fair Isaac, ILOG, and Computer Associates. Certain companies, such as Micromuse and Aspen Technology, sell
point solutions that compete with operations management applications based on G2 with respect to specific applications or uses. Several companies, including ILOG, Pavilion, and System Management Arts, offer operations management products
with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. 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.

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 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, cash flows, or financial position.

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

Our international revenues
represented 47%, 49%, and 54% of our total revenues for years ended December 31, 2005, 2004, and 2003, respectively. Our international revenues represented 48% and 49% of our total revenues for the three- and nine- months ended
September 30, 2006. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. Our international operations require significant management attention
and financial resources.

There are certain risks inherent in our international business activities including:



| |  |  | changes in foreign currency exchange rates;
| | - |  | -------------------------------------------



| |  |  | unexpected changes in politics and regulatory requirements;
| | - |  | -----------------------------------------------------------



| |  |  | tariffs and other trade barriers;
| | - |  | ---------------------------------



| |  |  | costs of localizing products for foreign countries;
| | - |  | ---------------------------------------------------



| |  |  | lack of acceptance of products in foreign countries;
| | - |  | ----------------------------------------------------



| |  |  | longer accounts receivable payment cycles;
| | - |  | ------------------------------------------



| |  |  | difficulties in building and managing international operations;
| | - |  | ---------------------------------------------------------------



| |  |  | tax issues, including restrictions on repatriating earnings;
| | - |  | ------------------------------------------------------------



| |  |  | weaker intellectual property protection in other countries;
| | - |  | -----------------------------------------------------------



| |  |  | economic weakness or currency related crises that may arise in different countries or geographic regions; and
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | the burden of complying with a wide variety of foreign laws.
| | - |  | ------------------------------------------------------------

These factors may have a material adverse effect on our future international sales and, consequently, on our business, results of operations, cash flows, or financial position.



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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 may develop 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 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, cash flows, or financial position.

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 that we offer 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, cash flows, or financial position.

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 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, cash flows, or financial position.

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 research and development in new
reasoning technologies may not lead to profitable commercialization.

We developed a pre-release version of a new software reasoning platform,
TrueManage, designed for handheld computing devices and targeted at application markets not currently addressed by our G2 and G2-based products. We have also prototyped a TrueManage application product called LifeVisor, a cell phone device for
self-management of chronic conditions such as diabetes and obesity. Development of TrueManage and LifeVisor is complex, requiring specialized technical expertise. The targeted handheld computing markets experience rapid advancements in related
technologies and applications. Our strategy was to distribute these products, particularly LifeVisor, through other companies that have significantly larger presence and scale in the targeted markets than we do. We found that it would require
significant funding to develop, launch, and build distribution channels for TrueManage and LifeVisor and have therefore suspended development. There can be no assurance that we will be able to successfully complete the development of TrueManage and
LifeVisor in the future. Our ability to use this technology and realize a return on this investment may be limited.



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Our stock price may be volatile and an investment in our common stock could suffer a decline in value.

The market price for our common stock may fluctuate significantly in response to a number of factors, some of which are beyond our control. These factors include:



| |  |  | actual or anticipated fluctuations in our operating results;
| | - |  | ------------------------------------------------------------



| |  |  | developments or disputes concerning proprietary rights;
| | - |  | -------------------------------------------------------



| |  |  | the loss of key management or technical personnel;
| | - |  | --------------------------------------------------



| |  |  | technological innovations or new products;
| | - |  | ------------------------------------------



| |  |  | governmental regulatory action;
| | - |  | -------------------------------



| |  |  | fluctuations in currency exchange rates;
| | - |  | ----------------------------------------



| |  |  | general conditions in the software industry;
| | - |  | --------------------------------------------



| |  |  | broad market fluctuations; and
| | - |  | ------------------------------



| |  |  | economic conditions in the United States or abroad.
| | - |  | ---------------------------------------------------

The stock market has recently experienced price and volume fluctuations. These fluctuations have particularly affected the market price of many software companies, often without regard to their operating performance.

Compliance with changing regulation of corporate governance and public disclosure may result in additional risks and expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ
rules, are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases and, as a result, their application in practice may evolve over time as new
guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.

We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and
standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and management time and attention. In particular, our efforts to comply with Section 404 of Sarbanes-Oxley and the related
regulations regarding our required assessment of our internal controls over financial reporting and our external auditors audit of that assessment has required the commitment of significant financial and managerial resources, and we expect our
compliance efforts to require the continued commitment of significant resources. Additionally, if our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies, our
reputation may be harmed, and we might be subject to sanctions or investigation by regulatory authorities, such as the SEC. Any such action could adversely affect our business and the market price of our stock.

Our common stock is quoted on the Pink Sheets, which limits the liquidity and could negatively affect the value of our common stock.

Our common stock is quoted on the Pink Sheets, which provides significantly less liquidity than a securities exchange, such as the New York Stock Exchange, the American
Stock Exchange, or the NASDAQ Global Market.

Purchasers of shares of our common stock may find it difficult to resell their shares at prices quoted in the
market or at all. There is currently a limited volume of trading in our common stock, and on some days there has been no trading activity at all. We cannot predict when or whether investor interest in our common stock might lead to an increase in
its market price or the development of a more active trading market or how liquid that market might become.

Additionally, because our common stock is
listed on the Pink Sheets, the liquidity of our common stock is impaired, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and limited coverage by security analysts and the news media,
if any, of our company. As a result, prices for shares of our common stock may be lower than might otherwise prevail if our common stock was traded on a national securities exchange, like the New York Stock Exchange, the American Stock Exchange or
the NASDAQ Global Market.



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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, contractors, 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.

Provisions in our corporate documents and
Delaware law could delay or prevent a change of control of the company, even if that change would be beneficial to our stockholders.

Our certificate of
incorporation and bylaws contain provisions that may make a change of control of the company difficult, even if it would be beneficial to our stockholders, including provisions governing the classification, nomination and removal of directors,
prohibiting stockholder action by written consent, regulating the ability of our stockholders to bring matters for action before annual stockholder meetings, and the authorization given to our board of directors to issue and set the terms of
preferred stock. In addition, Section 203 of the Delaware General Corporation Law would impose restrictions on mergers and other business combinations between us and any holder of 15 percent or more of our outstanding common stock.



|Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds
|------- | -----------------------------------------------------------

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 September 30, 2006, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased
in 2006, 2005 or 2004. The following table provides information about purchases by the company during the quarter ended September 30, 2006 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:

GENSYM PURCHASES OF EQUITY SECURITIES



|                  |  |                                                  |  |                             |   |                                                                                                          |         |                                                                                    |        
|----------------- |  | ------------------------------------------------ |  | --------------------------- | - | -------------------------------------------------------------------------------------------------------- | ------- | ---------------------------------------------------------------------------------- | -------
|Period            |  | Total Number ofShares Purchasedduring Period (1) |  | Average PricePaid per Share |   | Total Number ofShares Purchasedsince Adoption ofProgram asPart of PubliclyAnnounced
Plansor Programs (2) |         | Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs (3)
|07/01/06-07/31/06 |  | 0                                                |  | $                           |  |                                                                                                          | 501,300 |                                                                                    | 148,700
|08/01/06-08/31/06 |  | 0                                                |  |                             |  |                                                                                                          | 501,300 |                                                                                    | 148,700
|09/01/06-09/30/06 |  | 0                                                |  |                             |  |                                                                                                          | 501,300 |                                                                                    | 148,700

---

|(1) | We repurchased an aggregate of 501,300 shares of our common stock pursuant to the repurchase program that we publicly announced on July 1, 1998 (the Program).
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Our board of directors approved the repurchase by us of up to an aggregate of 650,000 shares of our common stock pursuant to the Program. Unless terminated earlier by resolution of
our board of directors, the Program will expire when we have repurchased all shares authorized for repurchase thereunder.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We do not anticipate making further purchases under this Program.
|--- | -----------------------------------------------------------------



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|ITEM 6. | Exhibits
|------- | --------

The following exhibits are filed as part of this Report
on Form 10-Q:



|              |  |                                                                                                                                                                                                         
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                             
|10.1          |  | Employment Offer Letter, dated August 3, 2006, between Gensym Corporation and Robert Ashton (Incorporated by reference to the Registrants Current Report on Form 8-K filed on August 08,
2006)         
|              | 
|10.2          |  | Severance Benefits Agreement, dated August 16, 2006, between Gensym Corporation and Carl Schultz (Incorporated by reference to the Registrants current Report on Form 8-K filed on August
22, 2006)    
|              | 
|10.3          |  | Severance Benefits Agreement, dated August 25, 2006, between Gensym Corporation and Lowell Hawkinson (Incorporated by reference to the Registrants current Report on Form 8-K filed on
August 25, 2006)
|              | 
|10.4          |  | Employment Offer Letter, dated August 3, 2006, between Gensym Corporation and Robert Ashton (Incorporated by reference to the Registrants Current Report on Form 8-K filed on August 08,
2006)         
|              | 
|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          |  | Certification 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.                                                      
|              | 
|32.2          |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                      

SIGNATURES

Pursuant to the requirements of the Securities 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: June 6, 2007 |  |  |  | /s/ STEPHEN D. ALLISON                                              
|                    |  |  |  | Stephen D. Allison                                                  
|                    |  |  |  | Chief Financial Officer (Principal Financial and Accounting Officer)



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EXHIBIT INDEX



|              |  |                                                                                                                                                                                                         
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                             
|10.1          |  | Employment Offer Letter, dated August 3, 2006, between Gensym Corporation and Robert Ashton (Incorporated by reference to the Registrants Current Report on Form 8-K filed on August 08,
2006)         
|              | 
|10.2          |  | Severance Benefits Agreement, dated August 16, 2006, between Gensym Corporation and Carl Schultz (Incorporated by reference to the Registrants current Report on Form 8-K filed on August
22, 2006)    
|              | 
|10.3          |  | Severance Benefits Agreement, dated August 25, 2006, between Gensym Corporation and Lowell Hawkinson (Incorporated by reference to the Registrants current Report on Form 8-K filed on
August 25, 2006)
|              | 
|10.4          |  | Employment Offer Letter, dated August 3, 2006, between Gensym Corporation and Robert Ashton (Incorporated by reference to the Registrants Current Report on Form 8-K filed on August 08,
2006)         
|              | 
|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          |  | Certification 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.                                                      
|              | 
|32.2          |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                      



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