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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark one)

Commission File Number: 0-27696

GENSYM CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (781) 265-7100

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12 (g) of the Act:

Common Stock, $.01 par value

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:   x  Yes     No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2):   ¨  YES     x NO

The aggregate market value of the common equity held by non-affiliates of the registrant, based on the last sale price for such stock on June 30, 2003, of $3,412,556.

As of March 24, 2004 there were 7,130,736 shares of the Registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement for the 2004 Annual Meeting of Stockholders to be held on Thursday, May 27, 2004 are incorporated by reference into Part III of this Form 10-K.

PART I

ITEM 1.    BUSINESS.

General

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

Our principal 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 7.1, in December 2003, with a number of new features, including support for integration of applications with enterprise systems using message-oriented middleware (MOM). We have begun field testing a pre-release version of G2 8.0, which when commercially released will represent a generational advance in our G2 product line.

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

We have a professional services group that can be engaged by our customers to develop applications or assist in the development of applications. However, many of our customers build their own applications. We also offer multiple 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:

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We have a direct sales force in the United States, Europe, and the Middle East. Our direct sales force is focused on the generation of new business in three vertical markets: chemical, oil, and gas; government; and water utilities. Our sales activities in these vertical markets involve a combination of direct sales to end users and indirect sales through partners. In areas where we do not have a direct sales force, or where we do not possess the requisite detailed industry knowledge to deploy our products successfully, we work with channel partners. Our partners pursue new business based on Gensym products in markets including business process management, various manufacturing sectors, telecommunications, and transportation. Channel partners are able to provide development, support, and training services to our customers. We have channel partners in North and South America, Europe, the Middle East, and the Asian-Pacific region.

Gensym Corporation was founded in 1986. Our principal office is located at 52 Second Avenue, Burlington, Massachusetts 01803, and our telephone number is (781) 265-7100. Our address on the World Wide Web is www.gensym.com. The information on our web site is not incorporated by reference into this Annual Report on Form 10-K and should not be considered to be a part of this report. We make available free of charge through our Web site our annual, quarterly, and current reports, and any amendments to those reports, as soon as reasonably practicable after we electronically file those reports with the Securities and Exchange Commission.

Our Products

Our core technology is an extensible, customizable software platform known as G2. G2 supports complex applications that emulate human reasoning and make operating decisions based on knowledge and often real-time data. We sell G2 and a number of products based on or complementary to it.

G2

G2, our core technology, is a comprehensive, object-oriented environment for rapidly building and deploying mission-critical, expert system applications that help improve complex business operations. G2 applies knowledge that combines the experience of operations personnel with analytical models constructed by engineers and business professionals, as well as past and real-time data, in order to reach conclusions, provide advice, and take real or simulated actions in a timely fashion. G2 can pursue multiple lines of reasoning based on this knowledge and can consider multiple problems concurrently. It can maintain records of historical data and results of its reasoning, which is important for ongoing, real-time management of operations. It also incorporates a broad array of integrated technologies that enable application developers to implement object-oriented applications without the need for conventional computer programming.

G2 enables an application developer to express objects, rules, models and procedures using structured natural language so that they can be readily understood and modified. The G2 development environment enables a developer to test an application using simulated data and to view the results graphically. In this way, an application can be tested under various scenarios before deployment. Rapid incremental application development can be done interactively to facilitate application improvements during prototyping, during development and even in deployment. Using G2’s ability to support rapid application development, a developer can show a dynamic, graphically animated prototype of an application to an end user at an early stage.

With G2, an application developer can model a process in terms of interrelated objects, which may be in graphical or schematic diagram form. Object-based graphical connections enable G2 to reason about the behavior of connected process objects. G2’s high-level representation of knowledge enables persons in many

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roles in an organization to develop applications more quickly and easily and to more effectively maintain and reuse those applications. Using Telewindows^® or the Telewindows ActiveX control, which are user-interface components of G2, developers at multiple geographic locations can work in teams to concurrently develop applications.

Applications built on G2 are portable and can operate across a number of computer platforms, so that solutions can be deployed on a wide range of platforms and later migrated to other computers and operating systems. G2 currently runs on PCs running Windows^® NT/2000/XP and on workstations from Compaq, Hewlett-Packard, IBM, Sun Microsystems and others. G2 currently runs under the Windows, the UNIX^® and the Linux^® operating systems.

G2 enables many procedures and rules to be active concurrently. While executing, a procedure or rule can be suspended to allow other computations to occur, or it can wait for a triggering event. G2 enhances the reliability of online applications by its facility to save “snapshots” of a process state and “warm boot” to the last saved state, so that an intelligent real-time system can resume after power failures or other interruptions.

G2 can support concurrent access to multiple sources of data and high-performance data exchange. Once an application is deployed, G2 components, such as Telewindows and G2 WebLink, enable multiple users to share that application concurrently. Telewindows and G2 WebLink are available on all G2 platforms as well as on PCs running Windows.

In March 2003, we released G2 version 7.0. This release contained important new functionality, including a new Windows user interface, support for extensible markup language (XML), and a data-historian bridge to facilitate integration with other applications. In December 2003, we released G2 version 7.1, which enhances a developer’s ability to integrate applications into systems through the addition of support for message-oriented middleware and other new capabilities. In February 2004, we began field testing a pre-release version of G2 8.0, which, when commercially released, will represent a generational advance of the G2 product.

NeurOn-Line

NeurOn-Line is a software platform that enables non-programmers who have little or no experience with neural networks to take advantage of this technology, particularly for online, dynamic applications involving prediction of process conditions. NeurOn-Line can identify and generate models of the physical behavior of processes and of relationships among process variables, when given a sufficient set of data. These models can then be used online to compare process behavior with the model’s prediction, and thus to control the process. Applications in NeurOn-Line are built graphically by selecting objects from menus, connecting them, and entering attribute and control information. NeurOn-Line Studio is a Windows desktop tool for off-line analysis, modeling, and design optimization of processes, based on data from a data historian or spreadsheet data arrays. To make the tool easy for process engineers to use, many technical decisions such as selection of relevant inputs, time delays, and network architecture are automated. Once a model has been built for a process, NeurOn-Line Studio enables users to discover more profitable ways to run that process through simulation and optimization. NeurOn-Line Studio models can be deployed either in a G2 environment or as Microsoft ActiveX objects in embedded Windows applications.

Optegrity

Optegrity is a software platform that enables process manufacturers to manage abnormal conditions that occur within process plants. Optegrity ensures sustained operational performance and continuous availability of production assets. It detects and resolves abnormal process conditions early, before they disrupt production and threaten quality and profits. Optegrity turns data into information to quickly identify, isolate and solve operational problems. Optegrity also enables process manufacturers to reduce off-specification production, minimize or eliminate unplanned shutdowns, improve operator productivity, lower production costs, raise operational safety levels, increase process utilization and enable non-stop operation.

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Intelligent Objects

Intelligent Objects are G2-based software objects that enable process manufacturers to manage abnormal conditions in specific types of production equipment, including furnaces, compressors, treaters, distillation columns, exchangers, pumps, sensors, controllers, valves, tanks and vessels. Intelligent Objects encapsulate expert knowledge about efficient and safe operation of these equipment types. Intelligent Objects are designed to proactively warn operators about abnormal equipment conditions and then guide their corrective responses so that they can effectively prevent costly shutdowns and process disruptions and avoid unsafe situations and environmental violations. Intelligent Objects complement Gensym’s Optegrity software—Intelligent Objects work directly with individual pieces of production equipment while Optegrity can detect and resolve problems occurring within an entire production unit or plant. Purchasers of Intelligent Objects can thus use the capabilities of Optegrity to build and deploy comprehensive applications that address abnormal condition problems impacting equipment, production units and plants. Intelligent Objects were introduced by Gensym in October 2003. The underlying technology was acquired from Gensym partner, Key Control, in June 2003.

Integrity

Integrity is an integrated software platform for intelligently managing faults and service levels in voice and data networks. Integrity maintains continuous availability by detecting, diagnosing and correcting problems before they affect services. The software helps users lower operating costs and improve service quality. Network service providers, network management companies, telecommunications equipment manufacturers and end-user corporations use Integrity to manage the performance of many different types of networks. Integrity can interoperate with a number of other network management programs, such as HP OpenView and IBM Tivoli, and provide intelligent operations support that addresses today’s complex communications operations problems. With Integrity, users have an enhanced ability to satisfy service-level agreements, to manage growth in a cost-effective manner, to minimize the risks of implementing new services and technologies, and to gain competitive advantage. Key functional uses include early detection of network problems, alarm/message/event filtering, alarm correlation across disparate platforms, root cause analysis, anticipating effects of network failures, and recommending and/or automating appropriate corrective actions.

ReThink

ReThink is a software platform for graphical simulation, analysis, and automation of business processes. As a simulation and analysis tool, ReThink enables users to model their business operation as it currently operates. Users can define key performance metrics and determine how business operations measure up against those metrics. From a model, users can simulate and analyze business process alternatives. Unlike other simulation tools, ReThink can deploy models to monitor and automate the execution of business processes. ReThink monitors business processes in real time, alerting operations personnel to potential problems as they occur. ReThink’s models can automate the online execution of business processes to help achieve sustained performance.

e-SCOR

e-SCOR is our product for supporting supply-chain design decisions. Based on the Supply Chain Council’s SCOR standard, e-SCOR drives strategic decisions by evaluating and comparing alternative supply-chain designs and management strategies. With e-SCOR, users can simulate various configurations, test the robustness of a supply-chain configuration, and identify the service levels required for each member of a supply-chain network. It can help identify the weak links and areas for improvement within a supply chain. e-SCOR is highly flexible and is ideal for performing “what-if” analyses.

Target Markets and Customers

Our customers include end users, value-added resellers, systems integrators and original equipment manufacturers. Many of the largest industrial corporations in the world are our customers. For example, in the

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manufacturing sector, customers include firms such as ABB, Dow Chemical, DuPont, Eli Lilly, El Paso Energy, Emerson, ExxonMobil, IMC Agrico, Invensys, LaFarge, Siemens, Shell and Toyota. In the government sector, our customers include the U.S. Department of Defense, Department of Energy, Mitre, and NASA. In the communications sector, our customers include Computer Sciences Corporation, Ericsson, Motorola and Pivetal.

Manufacturing has been our key area of expertise since our founding in 1986. We target manufacturers who seek to manage complex processes in order to improve product quality, increase the availability of production systems, and enhance the safe operation of their facilities. Working with our network of partners and with Gensym’s consulting organization, our customers deploy custom applications based on our products.

Our direct sales force operates in markets where we have a proven record of prior success and possess the necessary industry and process knowledge to provide the complex, high value-added services that our customers require. These direct markets are chemical, oil and gas, government, and water utilities. In other markets, where we do not possess the necessary industry expertise or market presence, such as business process management, various manufacturing sectors, telecommunications, and transportation, our partners sell and implement solutions using our products by leveraging their market presence, domain knowledge, and project experience.

Sales and Marketing

We employ both a direct sales force and select channel partners to bring our products and services to end users.

We have direct sales offices in the U.S., Europe, and the Middle East, and channel partners worldwide. In 2003, 2002, and 2001, we received 54%, 57%, and 44% of our total revenues, respectively, from international operations. Our domestic and international sales as a percentage of total revenues in 2003, 2002, and 2001 were as follows:

Our direct sales force sells to our major accounts and is focused on generation of new business in the chemical, oil and gas, government, and water utility vertical markets. Our direct sales efforts generated approximately 44%, 48%, and 45% of our product license revenues for 2003, 2002, and 2001, respectively. Because the sales cycle can be fairly protracted (typically six to twelve months) and because industry knowledge is a key requirement for making a successful sale, we also sell through our network of channel partners, who have access to customers and markets that would otherwise not be addressable by us. Our channel partners sell into all of our vertical markets and are the primary channel for development of new business in all markets not served by our direct sales force, including business process management, various manufacturing sectors, telecommunications, and transportation.

Our channel partners, who are systems integrators, original equipment manufacturers, and value-added resellers, are selected for their capability to provide end users with focused application solutions built on G2 and our G2-based products. These channel partners currently include organizations such as ABB, Emerson Process, Invensys, MinnovEx, Science Systems, and Siemens. Channel partners generated approximately 56%, 52% and 55% of our product license revenues for 2003, 2002, and 2001, respectively.

As part of our pre-sales process, our consultants might perform demonstrations at customer sites and assist customers in evaluating their technical requirements, in determining projected return on investment, and in

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implementing our technology. We host seminars and workshops at our larger offices and via the Web to demonstrate our products. We also offer basic and advanced training courses that teach prospective and new customers how to build and deploy applications using our software.

We market our products in the Asia-Pacific region and certain other regions through distributors. These distributors have technical competence in the application of G2 and G2-based products, market these products, provide local training and support assistance to customers, translate documentation, help localize software, and provide systems integration services.

Our marketing personnel engage in a variety of activities, including lead generation, in-person and Web-based seminars, trade shows, public relations, direct marketing, advertising, and promotion of customer applications for publication in industry magazines and journals.

Service and Support

We believe that a high level of customer service and support is critical to customer satisfaction and project and application success. Our software products are complemented by service offerings from our services organization, as well as from third-party integrators, resellers and other strategic partners. Our services organization is committed to meeting the consulting, implementation, education, and technical support requirements of our customers worldwide. Our services organization focuses on three areas of services:

Consulting and Implementation Services.    We offer a variety of application engineering and consulting services on a fee-for-service basis. We have expertise in applying our software in a variety of areas, including network and systems management, manufacturing process management, process design, modeling and simulation, water treatment, logistics, transportation, and finance. A key mission of our consulting staff is to assist end users and partners in the successful development and deployment of intelligent systems applications based on G2 and our other products.

Education Services.    We offer introductory, intermediate and advanced training courses for customers, partners, and potential users of our products. The courses are taught at our corporate headquarters in Burlington, Massachusetts, at our worldwide sales offices, and at customer locations. Many of our customers attend one to three weeks of training and implement their applications using the development features of our software. We offer a regular schedule of courses in our offices in North America and Europe, and special on-site training courses are offered around the world on an as-needed basis. Direct application-engineering services are available to support our end users and marketing partners on an international basis.

Customer Support Services.    We offer optional levels of customer service that include software updates, bulletin board access, various levels of telephone support, membership in the Gensym User Society, and access to HelpLink, our workflow-enabled Web application that greatly facilitates the interaction between our customers and ourselves and also serves as a knowledge database for recording solutions to past problems. Available service level options are priced differently and are selected by customers in accordance with their service needs. The highest level of customer service support includes 24x7 callback service. A maintenance contract is mandatory for the first year after purchase and may be renewed in subsequent years. We typically charge a percentage of license fees for customer service. We have service centers in North America and Europe. Local marketing partners provide components of customer service in the Asia-Pacific region and other areas of the world.

We have a user group, the Gensym User Society, which we manage. This organization consists of worldwide users of our software who have current maintenance contracts. An important function of the user group is to provide us with feedback from advanced users in regards to product performance and desired product enhancements. GUS 2004, a worldwide meeting of the Gensym User Society, is scheduled to be held in Nice, France in October 2004.

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Research and Development

We believe that future license sales and ongoing renewal of our service and support contracts depend upon our ability to regularly enhance our existing products, as well as to develop and introduce new products that keep pace with technological developments in the marketplace and address the increasingly sophisticated needs of our customers.

We typically develop new products and enhancements to existing products in response to market analyses and feedback from customers obtained by our customer support and consulting personnel. In addition we take new product initiatives to address targeted markets and industry standards. During 2003, we released new versions of our products to address new market requirements and update existing program code. The first major enhancement, in March 2003, was the release of G2 version 7.0, which contains many new features, including a new user interface based on Microsoft Windows’ standards, and support of the XML standard. Also in October 2003, we enhanced existing G2-based product offerings with the introduction of Intelligent Objects.

During 2003 we announced that we had begun transitioning to our next generation of G2 and G2-based software products. Our next generation is designed to reduce the time and effort it takes to develop and deploy G2 applications and to enhance application benefits. We expect to largely complete this transition by the end of 2004. We are maintaining compatibility of our next generation with our previous generation products to enable existing users to migrate their applications with minimal effort.

We expect our next generation of products to include the following capabilities:

In 2003, approximately 26% of our operating expense was committed to research and development, and we expect continuing investment in this area. While we expect that certain new products will be developed internally, we may, based on timing and cost considerations, acquire or license technology and/or products from third parties or consultants. Our research and development expenses were $3,303,000 in 2003, $3,217,000 in 2002, and $4,999,000 in 2001.

We are developing a new reasoning platform called TrueManage^™ with potential for widespread deployment beyond the existing markets for our G2 and G2-based products. The foundation for this work is a knowledge architecture that is designed for use on portable consumer devices, including cell phones and personal digital assistants (PDAs). The architecture is designed to support applications that manage everyday human activities through knowledge based, intelligent assistance. TrueManage’s knowledge-based architecture leverages our experience with our G2-based reasoning technology while building on popular software technologies such as Microsoft’s .NET.

We have also begun to develop a TrueManage application called LifeVisor^™, which is envisioned to be a cell phone based device for self management of chronic diseases, such as diabetes and obesity.

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Competition

In the manufacturing market, a number of software companies offer products that perform certain functions of G2 for specific applications. We believe that our products offer, in a single, seamlessly integrated manner, the most comprehensive set of software technologies available upon which to successfully build a broad range of expert operations management solutions. Competition in the expert manufacturing markets includes point solutions that resolve specific problems, real-time and expert system products, and traditional providers of custom programming services. For example, companies such as Aspen Technology, Pavilion and Ilog S.A. sell solutions that compete with our products with respect to specific applications or uses. An intelligent system based on point solutions, however, requires the integration of various software packages from different vendors, and is often difficult to maintain. Although our competitors’ systems may sometimes offer faster initial implementation, we believe that these systems do not provide the capabilities and flexibility needed to satisfy the changing requirements of a dynamic and complex operating environment. Point solutions may also fail to provide the extensibility to add rules and neural networks, and may be difficult to migrate to more powerful computers.

We face competition in the network management market from a number of companies, including Micromuse and System Management Arts (SMARTS). Both of these companies offer products that differ from our products in a variety of ways. Customers tend to select products based on the particular features and overall management approach to network availability each vendor delivers.

The principal competitive factors in all of the markets in which we compete are functionality, ease of use, price, distribution capabilities, quality, performance, customer references, customer support, and availability of application software implementation services. In order to maintain our competitive position, we must continue to enhance our existing products and introduce new products that meet evolving customer requirements.

Proprietary Rights

We rely primarily on a combination of patent law, copyright law, trade secret law, and contract law to protect our proprietary technology. We have one patent covering specific aspects of our core product, G2, and have applied for patents for certain new product developments. The scope of the existing patent relates to application security. Specifically, the patent recognizes a unique means for restricting user access to the configurable portion of the application’s user interface, thereby making the application secure. We do not have any registered copyrights. We also have internal policies and systems to limit access to and keep confidential our trade secrets. We distribute our products under software license agreements that contain various provisions to protect our ownership of and the confidentiality of the underlying technology. We also require our employees and other parties with access to our confidential information to execute agreements prohibiting the unauthorized use or disclosure of our technology. In addition, we periodically review our proprietary technology for its ability to be patented. Despite these precautions, it may be possible for a third party to misappropriate our technology or to develop similar technology independently. In addition, effective patent, copyright and trade secret protection may not be available in every foreign country in which our products are distributed.

Certain technology used in our products is licensed from third parties. We believe that, in general, comparable licenses are available on commercially comparable terms from a number of licensors and do not believe that any of our products are significantly dependent upon such licensed technologies.

Despite our efforts to protect our proprietary rights, attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. There can be no assurance that others will not develop products that infringe upon our proprietary rights or are similar or superior to those developed by us. Policing the unauthorized use of our products is difficult. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and

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scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, results of operations and financial condition. Also, there can be no assurance that third parties will not assert infringement claims against us in the future with respect to current or future products. Any such assertion could require us to enter into royalty arrangements or result in costly litigation, which could have a material adverse effect on our business, results of operations, and financial condition.

Gensym^®, G2^®, NeurOn-Line^®, ReThink^®, G2 Real-Time Expert Systems^® and Telewindows^® are our registered trademarks. The Gensym logo, Intelligent Objects, Optegrity, Integrity and Symcure are our trademarks. We have filed applications to register Gensym, G2, and NeurOn-Line in certain foreign jurisdictions. In addition, we have an exclusive, worldwide, royalty-free, perpetual license from Microsoft Corporation to use the trademark Telewindows.

Backlog

We ship software products within a short period after receipt of a customer purchase order and typically do not have a material backlog of unfilled orders of software products at any point in time. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter.

Employees

As of December 31, 2003, we had 77 full-time employees, including 19 employees in sales and marketing, 18 employees in product development, 14 employees in consulting services, 10 employees in customer support, production and licensing, and educational services, and 16 employees in general and administrative functions. Of these employees, 54 were located in the United States and 23 were located in foreign countries. None of our employees are represented by a labor union, and we believe that our employee relations are good.

ITEM 2.    PROPERTIES.

At December 31, 2003, our headquarters and principal operations were located in a leased facility with 27,250 square feet in Burlington, Massachusetts. The lease on the Burlington facility expires on January 31, 2006, with an option to renew for an additional term of five years. In addition to rental expenses, we must also pay an allocated portion of operating expenses and taxes each year. We also lease sales office space in the metropolitan areas of several cities throughout North America, as well as France, Italy, The Netherlands, and Tunisia. We believe that our existing facilities are adequate for our current needs and that suitable additional space will be available as required.

ITEM 3.    LEGAL PROCEEDINGS.

On November 13, 2001, we and our directors were served with a complaint filed by one of our stockholders, Special Situations Fund, III, L.P., in Delaware Chancery Court in and for New Castle County. The lawsuit asserted claims for, among other things, alleged breach of fiduciary duty and waste of corporate assets in connection with our rejection of a merger proposal by Rocket Software, the adoption of our proposed rights offering, and the execution of a letter of intent with Rocket Software relating to the sale of our NetCure product line. The complaint sought injunctive relief with respect to the Rocket Software merger proposal, the proposed rights offering and the sale of the NetCure product line to Rocket Software. On November 16, 2001, we and our directors were served with an amended and supplemental complaint further asserting that our directors breached fiduciary duties by consummating the sale of the NetCure product line to Rocket Software and allegedly refusing to negotiate with Rocket Software in connection with its merger proposal. In addition, the amended complaint added Rocket Software as a defendant and asserted a claim against Rocket Software for aiding and abetting the alleged breaches of fiduciary duties. The amended complaint sought injunctive relief with respect to the Rocket Software merger proposal, rescission of the NetCure sale, and compensatory and/or rescissionary monetary damages. On November 26, 2001, the court conducted a telephonic hearing on the plaintiffs’ motion for

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expedited proceeding and denied the motion at the conclusion of that hearing. On November 27, 2001, we were advised by plaintiffs counsel that, in light of the court’s decision on the motion to expedite proceedings, the plaintiffs intended to file a further amended complaint. To date, we have not been served with a further amended complaint.

On August 1, 2001, we received a letter from the counsel for Pavilion Technologies, Inc. alleging that we are infringing one or more claims of fourteen of Pavilion’s patents related to neural networks, expert systems and the control of processes. We have not been served with a complaint in this matter nor received any correspondence from Pavilion since early in 2002.

We are involved in various other 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.

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

None.

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PART II.

ITEM 5.    MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock, $0.01 par value per share, is currently quoted on the OTC Bulletin Board under the symbol “GNSM”. The following table sets forth the high and low closing prices per share of our common stock for the quarterly periods indicated on the OTC Bulletin Board. Due to the low trading volume in our common stock, the reported trading prices may not be indicative of the value of our common stock.

We have never declared or paid cash dividends on our capital stock. We do not anticipate paying any cash dividends in the foreseeable future. Payment of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion.

There were approximately 132 holders of record of our common stock as of March 29, 2004. This number does not include stockholders for whom shares are held in a “nominee” or “street” name.

We have not sold any unregistered securities in the last three years.

Information with respect to securities authorized for issuance under our equity compensation plans will be included in our definitive Proxy Statement for our 2004 Annual Meeting of Stockholders to be held on May 27, 2004 and is incorporated herein by reference.

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ITEM 6.    SELECTED FINANCIAL DATA.

The following selected financial data are derived from our audited consolidated financial statements. When you read this selected financial data, it is important that you also read our Management’s Discussion & Analysis of Financial Conditions and Results of Operations, and our historical consolidated financial statements and related notes included in this report. The historical results are not necessarily indicative of the operating results to be expected in the future.

The consolidated financial statements for fiscal years 1999 through 2001 were audited by Arthur Andersen LLP, which has ceased operations. A copy of the report previously issued by Arthur Andersen LLP on the our financial statements as of December 31, 2001 and 2000, and for each of the three years in the period ended December 31, 2001, is included elsewhere in this document. This previously issued report has not been reissued by Arthur Andersen LLP.

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Forward-Looking Statements

This annual report contains forward-looking statements and information relating to us and our subsidiaries, which are based on management’s beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used herein, words such as “anticipate”, “believe”, “estimate”, ‘expect”, “intend” and similar expressions, as they relate to us or our management identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth below under the caption “Factors Affecting Future Operating Results.” Should one or more of these risks or uncertainties materialize, or should underlying assumption prove incorrect, actual results may vary materially from those described herein 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. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the discussion under “Factors that May Affect Future Results”.

Business Overview

We were incorporated in Delaware in 1986 to develop and sell software products for expert operations management. Our flagship product has been, and continues to be, G2, which can emulate the reasoning of human experts as they assess, diagnose, and respond to unusual operating situations or as they seek to optimize operations. We have also developed a number of market-specific products using G2 as a platform. Since our inception, we have sold over 17,000 licenses to customers in a variety of industries.

Over the years we have developed and improved G2 and its related products on a regular basis, in terms of performance, functionality and ability to integrate with a wide variety of industry-standard products and protocols. We released a major version of G2, version 7.0, in March 2003, which constituted a significant advance in our product. Version 7.0 included many significant enhancements intended to bring G2 into line with current industry standards. Version 7.1 was released in December 2003, adding to G2’s integration capabilities with support for message-oriented middleware and other capabilities. We have begun field testing a pre-release version of G2 8.0, which when commercially released will represent a generational advance in our G2 product line.

In 2003, we refocused our direct sales force on generation of new business in three vertical markets: chemical, oil and gas; government, and water utilities. Our sales to these vertical markets involve a mix of direct sales to end users and indirect sales through partners. In geographic areas where we do not have direct sales force coverage, or in market sectors where we do not possess the requisite detailed industry knowledge to deploy our products successfully, we work with channel partners. These partners pursue new business based on Gensym products in various markets including business process management, various manufacturing sectors, telecommunications, and transportation.

To assist our end users and partners in develop applications, we offer professional services in the U.S., Europe, and the Middle East. In some cases we enter into fixed price contracts to deliver application solutions.

We conduct our business in North and South America, Europe, the Middle East, Africa and the Asia-Pacific region. In 2003, approximately 32% of our revenues were generated from license sales, 15% from consulting and training and 53% from customer support services. Prices for our products are generally denominated in U.S. dollars, although we do some business in local currencies. The chemical, oil and gas industries are a major market for us. The U.S. Government, particularly the Department of Defense, is a major customer. We have several significant OEM partners, among them Siemens, Ericsson, and Motorola.

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Detailed domain knowledge and expertise are critical elements for the success of our product implementations. Therefore, we frequently work closely with partners who are able to provide such expertise and are familiar with particular markets and applications. Our partners are value-added resellers, original equipment manufacturers, and system integrators. Partners account for approximately half of our product revenues.

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. 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 are believed 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.

We believe the following accounting policies are critical to an understanding of our consolidated financial statements and involve the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We derive revenues from two primary sources: (1) product licenses and (2) services revenues, which include maintenance, consulting, and education revenues. While the basis for software revenue recognition is substantially governed by the provisions of Statement of Position No. 97-2, Software Revenue Recognition (SOP 97-2), and Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, (SOP 98-9), both issued by the American Institute of Certified Public Accountants, and SEC Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements (SAB 101), we also apply the provisions of Statement of Position No. 81-1 Accounting for Performance of Construction Type and Certain Production-Type Contracts, (SOP 81-1) to certain contracts involving the sale of product licenses and services. We do not generally provide for rights of return related to sales of our product licenses.

We exercise judgment and use estimates in connection with the determination of the amount of software license and services revenues to be recognized in each accounting period. Our judgments and estimates related to revenue recognition primarily relate to the determination of fair value of services when sold together with licenses and our estimates of costs to complete under contracts accounted for under the percentage of completion method of accounting. If our estimates differed from those reflected in our financial statements, the amount and timing of our revenues may be impacted in a particular period.

Accounts Receivable and Allowance for Doubtful Accounts

We make estimates of the collectability of our accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Uncertainties affecting our estimates include future industry and economic trends and the related impact of the financial condition of our customers, as well as the ability of our customers to generate cash flows sufficient to pay us amounts due. If circumstances change, such as higher than expected defaults or an unexpected material adverse change in a customer’s ability to meet its financial obligations to us, our estimates of the recoverability of amounts due us could be reduced by a material amount which may have a material effect on our financial position, results of operations or cash flows.

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Foreign Currency Translation

Our contracts with our customers are generally denominated in U.S dollars or Euros. We transact business in various countries and thus have exposure to fluctuations 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 statement of operations. 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.

To date, we have not used financial instruments to hedge operating activities denominated in foreign currencies. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

Our international business is subject to risks typical of an international business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially and adversely affected by changes in these or other factors.

Accounting for Income Taxes

As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax liabilities together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes as well as net operating losses. These differences result in deferred tax assets and liabilities, including net operating loss carryforwards, research and development tax credits and foreign tax credits. A portion of these net operating losses are a result of stock option deductions, and therefore the benefit from these losses will be charged directly to additional paid in capital. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent that we establish a valuation allowance or increase this allowance in a period, the impact will be included in the tax provision in the statement of operations.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We have recorded a valuation allowance of due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of certain net operating loss carryforwards and research and development tax credits, before they expire. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance that could materially impact our financial position and results of operations. At December 31, 2003, we continued to have a 100% valuation allowance against our deferred tax assets.

We have taken the position under APB 23, Accounting for Income Taxes—Special Areas, that all earnings of its foreign subsidiaries are permanently reinvested. Therefore, no U.S. taxes have been provided on these unremitted accumulated foreign earnings.

The above listing is not intended to be a comprehensive list of all of our accounting policies. Our significant accounting policies are more fully described in Note 1 to our consolidated financial statements. See our audited consolidated financial statements and notes thereto which begin on page 35 of this Form 10-K which contain accounting policies and other disclosures required by accounting principles generally accepted in the United States.

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Results of Operations

The following is an overview of our results of operations for the last three years:

The following table sets forth certain consolidated financial data as a percentage of our total revenue for the last three years:

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Years Ended December 31, 2003 Compared with Year Ended December 31, 2002

Revenues

We derive our revenues from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products. Services revenues consist of fees for maintenance contracts, consulting services, and training courses related to our products.

Total revenues were $14,623,000 for the year ended December 31, 2003 as compared to $17,451,000 for the same period in 2002, a decrease of $2,828,000, or 16%. The reduction in revenue is attributable to a decrease of $1,745,000, or 27%, in product revenues and a decrease of $1,083,000, or 10%, in service revenues. Product revenues fell mainly as a result of the continued economic slowdown, the volatile situation in the Middle East, and a restructuring of the sales force during the first half of the year. Service revenues decreased due to several factors including a decrease in new maintenance contracts, the suspension of a significant consulting project in the United Kingdom due to acquisition of our customer by another entity, and an overall decrease in product revenues. International revenues accounted for 54% of total revenues in 2003 and 57% in 2002, while U.S. revenues accounted for 46% and 43% in 2003 and 2002, respectively.

Product.    Product revenues declined by $1,745,000, or 27%, to $4,728,000 for the year ended December 31, 2003 from $6,473,000 in 2002. Europe product revenue was $1,821,000, or 39% of total product revenue in 2003, and $3,406,000, or 53% of total product revenue in 2002. Product revenues in Europe fell mainly as a result of the continued overall economic downturn, the fact that important next-generation G2 capabilities had not yet been released, and the war in Iraq’s impact on both key markets (chemical, oil & gas) and regions (Middle East). U.S. product revenues remained relatively unchanged in 2003 from 2002, while we saw a slight decrease in Asia product revenue, specifically in the manufacturing sectors.

Services.    Service revenues decreased $1,083,000, or 10%, to $9,895,000 for the year ended December 31, 2003 from $10,978,000 in 2002. Maintenance revenues decreased $677,000, or 8%, to $7,814,000 in 2003 compared to $8,491,000 in 2002. Consulting revenues decreased $266,000, or 12%, to $1,864,000 in 2003 compared to $2,130,000 in 2002. The decrease in consulting revenues was due to the suspension of a significant consulting project in the United Kingdom, and the overall decrease in product revenues. Training revenues decreased by $140,000, or 39%, to $217,000 in 2003 compared to $357,000 in 2002. Travel restrictions and bans within some companies contributed to the reduction in training revenues.

Cost of Revenues

Cost of revenues consists of consulting labor, technical support costs, and the costs of material and labor involved in producing and distributing our software. Cost of revenues was $3,800,000 for the year ended December 31, 2003 as compared to $3,587,000 for the same period in 2002, an increase of $213,000, or 6%. The increase in cost of revenues was primarily the result of our new sales commission plan, amortization expense

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related to certain intangible assets acquired in 2003 and the pass through cost of specialized software purchased for a customer project. This increase was partially offset by a reduction in bonus expense. The average number of employees associated with the cost of revenue increased by one, to an average of 26 employees in 2003. There were 24 full-time cost of revenues employees as of December 31, 2003.

Product cost was $707,000 in 2003, a decrease of $80,000, or 10%, from $787,000 in 2002. The decrease in product costs is attributable to a $127,000 decrease in salary and salary related expenses, and to a reduction in royalty expense of $52,000 offset by an increase of $75,000 for the purchase of specialized software for a customer project and an increase of $63,000 related to amortization expense for intangible assets purchased in 2003. The average number of employees associated with product cost decreased by one in 2003. There were three full-time product employees as of December 31, 2003.

Services cost was $3,093,000 in 2003, an increase of $293,000, or 11%, from $2,800,000 in 2002. The increase was primarily the result of a $121,000 increase in salary expense, $149,000 increase in commissions, and a $39,000 increase in travel expenses offset by a decrease of $58,000 in bonus expense. The average number of employees associated with service cost increased by two to an average of 22 employees in 2003. There were 21 full-time service employees as of December 31, 2003.

Gross margin on revenues decreased from 79% in 2002 to 74% in 2003.

Operating Expenses

Total operating expenses were $12,807,000 in 2003 (88% of total revenues) as compared to $11,922,000 (68% of revenues) in 2002, an increase of $885,000, or 7%. Operating expenses for the year ended December 31, 2003, excluding restructuring charges, were $12,591,000 (86% of total revenue), an increase of $669,000, or 6%, from $11,922,000 in 2002. The increase in operating expenses were primarily the result of increases in salaries, accounting and legal fees, and commissions, offset by a decrease in bonus expense. The average number of employees associated with operating expenses increased by five to an average of 61 employees in 2003. There were 53 full-time operating employees as of December 31, 2003.

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. For the year ended December 31, 2003, sales and marketing expenses increased $280,000, or 5%, to $5,580,000 (38% of total revenues) compared to $5,300,000 (30% of total revenues) in 2002. The increase in expenses was primarily the result of increases in salaries of $346,000, commissions of $79,000, and travel of $129,000. These increases were offset by decreases in contractors of $215,000 and marketing materials for sales and lead-generation activities of $43,000. The average number of employees associated with sales and marketing increased by two to an average of 23 employees in 2003. There were 19 full-time sales and marketing employees as of December 31, 2003.

Research and Development.    Research and development expenses consist primarily of costs of personnel, equipment, and facilities. For the year ended December 31, 2003, research and development expenses increased $86,000, or 3%, to $3,303,000 (23% of total revenue), compared to $3,217,000 (18% of total revenue) in 2002. The increase in expenses were primarily the result of an increase in our funding of the TrueManage project of $320,000, an increase in support costs of $140,000, a decrease in salaries and benefits of $81,000, a decrease in bonus of $195,000, and a decrease in engineering support from internal consultants of $125,000. The average number of employees associated with research and development increased by two to an average of 20 employees in 2003. There were 18 full-time engineers as of December 31, 2003.

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. General and administrative expenses increased $303,000, or 9%, to $3,708,000 (25% of total revenue) for the year ended December 31, 2003 compared to $3,405,000 (20% of total revenue) in 2002. Professional, accounting and legal

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fees were $1,588,000 in 2003 as compared to $841,000 in 2002. This represents an increase of $747,000, or 89%, from 2002. During 2003 we incurred significant accounting and legal expense due to the turnover of accounting personnel and new regulations passed by the SEC and Congress. Bonus expense decreased by $279,000 from 2002. The company also received value added tax reimbursements of $183,000 that were credited against general and administrative expense during 2003. The average number of employees associated with general and administration increased by one to an average of 18 employees in 2003. There were 16 full-time administration employees as of December 31, 2003.

Restructuring Charge.    In June 2003, our board of directors approved a workforce reduction plan. Given the uncertain economic conditions, we decided to take certain actions to reduce our expenses to a level commensurate with current levels of revenue. The restructuring plan consisted of reductions in employee headcount totaling 15 employees, from all operating groups and geographic areas. In accordance with this plan, we recorded a restructuring charge of $216,000 in 2003. The charge was based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe, and related legal costs. At December 31, 2003, there remains an accrual of $126,000 that is expected to be paid by the end of June 2004.

Other Income (loss)

Other income (loss) consists primarily of foreign exchange translation gains and losses, interest income and interest expense. For the year ended December 31, 2003, other income was $245,000, compared to other loss of $162,000 for the year ended December 31, 2002. We realized foreign exchange gains of $226,000 due to the strengthening of the Euro currency during 2003, compared to foreign exchange losses of $211,000 in 2002. Interest income for the year ended December 31, 2003 decreased by $54,000, or 64%, primarily as a result of lower average cash balances. Interest expense for the year ended December 31, 2003 increased $5,000, or 31%, to $21,000 compared to $16,000 in 2002.

Income Taxes

We recorded a provision for income taxes of $44,000 and $136,000 for the years ended December 31, 2003 and 2002, respectively. The tax provisions for 2003 and 2002 primarily represent taxes on income generated in certain foreign jurisdictions, where we do not have operating loss carryforwards, and withholding taxes on sales in certain foreign jurisdictions of $103,000.

Years Ended December 31, 2002 Compared with Year Ended December 31, 2001

Revenues

Total revenues were $17,451,000 for the year ended December 31, 2002 as compared to $20,181,000 for the same period in 2001, a decrease of $2,730,000, or 14%. Total revenues decreased as a result of a decrease in sales of application consulting services and product maintenance contracts. Maintenance revenues fell by $2,901,000, mainly as a result of customers electing not to renew their maintenance contracts due to (1) fears about our financial viability after our 2001 restructuring, and (2) the reduction in the frequency and number of enhancements to G2 and G2-related products during 2000 and 2001, when we were focused on developing new network management products. We have been conducting an active campaign to re-sign customers who have let their support contracts lapse. International revenues accounted for 57% of total revenues in 2002 and 44% in 2001 while U.S. revenues accounted for 43% and 56% in 2002 and 2001, respectively.

Product.    Product revenues increased by 3% to $6,473,000 for the year ended December 31, 2002 from $6,302,000 in 2001. License sales were primarily to existing customers.

Services.    Services revenues decreased $2,901,000, or 21%, to $10,978,000 for the year ended December 31, 2002 from $13,879,000 in 2001. The decrease in service revenues was primarily due to a decrease in application consulting revenues and a decrease in customer maintenance contracts. Consulting revenues decreased $1,665,000, or 44%, and maintenance renewals decreased $1,071,000, or 11%, in 2002 compared to 2001. The declining strength of the US economy had caused widespread loss of business in most sectors of the consulting market, including those in which we compete.

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Cost of Revenues

Cost of revenues was $3,587,000 for the year ended December 31, 2002 and $4,734,000 for the same period in 2001, a decrease of $1,147,000 in 2002, or 24%. The decrease in cost of revenues was primarily the result of our 2001 restructuring actions that reduced overall operating expenses. The average number of employees associated with the cost of revenue decreased by 11, to an average of 25 employees in 2002, compared to an average of 36 employees during 2001. This resulted in personnel related expenses decreasing approximately $1,103,000 for 2002.

Product cost was $787,000 in 2002, a decrease of $182,000, or 19%, from 2001. The decrease in product costs is attributable to a $159,000, or 35%, decrease in personnel-related expenses, offset by a $12,000 increase in royalty fees and an increase in discretionary expenses of $36,000.

Services cost was $2,800,000 in 2002, a decrease of $965,000, or 26%, from $3,765,000 in 2001. The decrease was primarily a result of lower personnel-related expenses of $944,000, or 33%, and a reduction in allocated facilities support costs of $90,000, or 16%, from 2001 as a result of our 2001 restructuring actions, offset by an increase in discretionary spending of $4,000. The average number of employees associated with service cost decreased by 11 to an average of 20 employees in 2002 from an average of 31 employees in 2001. The headcount decrease directly resulted from the cut back in both consulting and customer support personnel following the restructure in 2001.

Gross margin on revenues improved from 76% in 2001 to 79% in 2002, reflecting the personnel cost reductions referred to above.

Operating Expenses

Total operating expenses were $11,922,000 in 2002 (68% of total revenues) as compared to $20,813,000 (103% of revenues) in 2001. Operating expenses for the year ended December 31, 2001, excluding restructuring charges, were $18,254,000 (90% of total revenue). The decrease in operating expenses was primarily a result of the restructuring plan to reduce operating costs undertaken in 2001. The average number of employees associated with operating expenses decreased by 33 to 57 during 2002, resulting in a decrease of personnel related operating expenses for 2002 of approximately $3,882,000. There were 53 employees associated with operating expenses at December 31, 2002.

Sales and Marketing.    For the year ended December 31, 2002, sales and marketing expenses decreased $3,565,000, or 40%, to $5,300,000 (30% of total revenues) compared to $8,865,000 (44% of total revenues) in 2001. The decrease in expenses resulted from a decrease in personnel related costs of $2,103,000 and a decrease in allocated facilities support costs of $395,000, or 48%. The number of employees associated with sales and marketing on average decreased by 17, from an average of 38 employees in 2001 to an average of 21 employees during 2002.

Research and Development.    For the year ended December 31, 2002, research and development expenses decreased $1,782,000, or 36%, to $3,217,000 (18% of total revenue), compared to $4,999,000 (25% of total revenue) in 2001. The decrease in expenses resulted from a decrease of personnel related costs of $1,112,000 and a decreased share of allocated facilities support expenses of $328,000. The number of employees associated with research and development, increased by 7 during 2002 to 21 employees at December 31, 2002. However, the average number of employees in 2002 was 19, compared to 29 in 2001. During 2001, our on-going restructuring efforts and the sale of our NetCure product line in November 2001 to Rocket Software resulted in decreases in research and development expenses for 2002.

General and Administrative.    General and administrative expenses consist primarily of personnel costs for finance, administration, operations, and general management, as well as legal and accounting expenses. General and administrative expenses decreased $985,000, or 22%, to $3,405,000 (20% of total revenue) for the year ended December 31, 2002 compared to $4,390,000 (22% of total revenue) in 2001. The decrease in expenses was

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primarily due to reductions in personnel costs and reduced legal expenses. Personnel reductions and reduced benefit-related expenses accounted for a decrease of $667,000, or 3%, for the year ended December 31, 2002 compared to the year ended December 31, 2001. The number of employees associated with general and administrative expenses decreased by 2, or 11%, to 16 employees at December 31, 2002 from 18 employees at December 31, 2001. Legal expenses decreased $636,000, or 77%, for the year ended December 31, 2002 from the year ended December 31, 2001. During 2001, we incurred significant legal expenses in conjunction with our restructuring, our bridge financing, and a proposed rights offering.

Restructuring Charge.    In January, April, July, and August 2001, we undertook restructuring plans to reduce operating costs. For the year ended December 31, 2001 we incurred restructuring charges of $2,559,000. The restructuring plans consisted of reductions in employee headcount and the closing of certain offices. The reductions in employee headcount were from all operating groups and from all geographical areas and totaled approximately 45 in January, 13 in April, 12 in July, and 50 in August. The restructuring charge included a non- cash amount of approximately $657,000 related primarily to cumulative translation adjustments associated with the closing of foreign offices and liquidation of subsidiaries in Europe, the Far East and Asia-Pacific, and approximately $1,902,000 related to employee severance. Approximately $1,663,000 was paid out for employee severance in the year ended December 31, 2001 related to the restructuring actions. The remaining $239,000 of severance payments was paid in the year ended December 31, 2002.

Other Income (Loss)

Other income (loss) consists primarily of interest income, interest expense, foreign exchange transaction gains and losses, and the sale of assets. For the year ended December 31, 2002, other loss was $162,000, compared to other income of $1,903,000 for the year ended December 31, 2001. The income in 2001 consisted primarily of $2,000,000 in net proceeds from the sale of our NetCure product line to Rocket Software. Interest income for the year ended December 31, 2002 increased by $62,000, or 270%, primarily as a result of higher average cash balances. Interest expense for the year ended December 31, 2002 decreased $23,000, or 59%, to $16,000 compared to $39,000 in 2001. During 2001, we incurred interest expense on the borrowings from bank financing arrangements and bridge loans. There were no significant borrowings in 2002.

Income Taxes

We recorded a provision for income taxes of $136,000 and $286,000, for the years ended December 31, 2002 and 2001, respectively. The tax provisions for 2002 and 2001 primarily represent taxes on income generated in certain foreign jurisdictions, where we do not have operating loss carryforwards and withholding taxes on sales in certain foreign jurisdictions.

Liquidity and Capital Resources

Our December 31, 2003 cash and cash equivalents were $1,818,000, a decrease of $2,066,000 from December 31, 2002. Cash used in operations in 2003 was $1,867,000 compared to cash provided by operations of $1,872,000 in 2002. Cash used in operations in 2003 was primarily due to a net loss of $978,000, net of non-cash expenses (depreciation and amortization, loss on disposal of equipment and the non-cash portion of compensation. In addition, cash flows used in operations were impacted by a decrease in deferred revenue of $249,000, a paydown of accounts payable and accrued expenses of $557,000, and increases in accounts receivable of $49,000 and prepaid expenses and other assets of $33,000.

Cash used by investing activities in 2003 was $448,000 compared to $313,000 in 2002 and primarily consisted of $327,000 used to purchase equipment, of which $102,000 was financed through a capital lease obligation and the purchase of certain intangible assets for $250,000.

Cash provided by financing activities in 2003 was $57,000, which consisted of $102,000 of proceeds received from a long-term borrowing in connection with a capital lease of computer equipment. Principal payments on capital leases amounted to $143,000 and were partially offset by $98,000 from the issuance of common stock under our stock purchase plan and exercise of stock options by employees.

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On March 28, 2001, we entered into an accounts receivable financing agreement with Silicon Valley Bank. The financing agreement provided us the ability to borrow up to 80% of our qualified and eligible gross domestic accounts receivable up to a maximum of $2,500,000. Borrowings under this agreement were at an interest rate of 2% per month of the average gross daily purchase account balance, plus an administration fee of 1% of gross purchased account receivables. This facility was terminated on August 31, 2003 because it had not been used since October 2001.

We currently finance our operations, along with capital expenditures, primarily through cash flows from operations, short-term financing arrangements, and our current cash and cash equivalents.

Our financial statements have been prepared under the assumption that we will continue as a going concern. Based on current forecasts, management believes that we have sufficient liquidity to finance operations for the next twelve months. 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.

Contractual Obligations

Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We have capital leases for certain communications and computer equipment. Our obligations relating to these leases at December 31, 2003 are as follows:

Rent, office lease, and equipment lease expense under the above leases were approximately $1,158,000 in 2003, $1,598,000 in 2002 and $1,798,000 in 2001.

Off-Balance Sheet Arrangements

We have not entered into any off-balance sheet arrangements that have or are likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, or capital expenditures as capital resources that are material to investors.

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 December 31, 2003, 501,300 shares had been repurchased at a cost of approximately $1,869,000. We have not purchased any shares of our common stock since March 1999. In 2003, we reissued 76,131 shares with a weighted average fair value of $0.76 to non-employee directors and two consultants. In 2002, we reissued 35,957 shares with a weighted average fair value of $0.68 to employees, non-employee directors and a consultant. As of December 31, 2003, 389,212 shares remained in treasury at a cost of $1,458,000.

Related Party Transactions

On January 9, 2002 we entered into a three-year original equipment manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation founded by a one of our employees who continues to work for us. The agreement calls for the payment of royalties, based on a fixed and determinable percentage of

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the product sale 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. We paid Integration Objects approximately $162,000 and $61,000 during the years ended December 31, 2003 and 2002, respectively, under this agreement. At December 31, 2003, we had unpaid royalties to Integration Objects of $21,000.

Recent Accounting Pronouncements

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

In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred and nullifies EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity commits itself to an exit plan. In SFAS No. 146, an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for the initial measurement of the liability. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material effect on our consolidated financial position or results of operations.

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104), which supercedes SAB 101, Revenue Recognition in Financial Statements. The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on the Company’s financial statements.

Factors That May Affect Future Results

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

We incurred operating losses for two out of the three years ending December 31, 2003, including fiscal year 2003. In August 2001, we announced a strategic restructuring of our company that included a 40% reduction in workforce, a realignment of our software and services product lines, and a renewed focus on our existing customers. With the restructuring, we achieved profitability for each fiscal quarter of 2002 and for the year ended December 31, 2002, although our revenues declined from the fiscal year ended December 31, 2001. In June of 2003, our Board of Directors approved a workforce reduction plan. We incurred operating losses in each of the first three quarters of 2003 and for the year ended December 31, 2003 but achieved net income profitability in the fourth quarter of 2003. Our ability to achieve and maintain profitability is dependent on continued revenue from new and existing customers and expense control. There can be no assurance that we will return to profitability.

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We are increasingly 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 revenue, as software maintenance fees have become a larger component of our total revenues, representing 44%, 39% and 37% of our total revenues in the years ended December 31, 2003, 2002 and 2001, respectively. 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 56%, 52% and 55% of our product revenues in years ended December 31, 2003, 2002 and 2001, respectively. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing successful G2-based applications could have a material adverse effect on our business, results of operations, cash flows or 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, or 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 and our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better funded sales and marketing operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, 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

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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.

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.

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

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

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

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

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

Our international revenues represented 54%, 57%, and 44% of our total revenues for years ended December 31, 2003, 2002, and 2001, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international

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portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating documentation into local languages, fluctuations in the value of international currencies including the Euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, cash flows, or financial position.

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

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

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.

Certain companies, such as Micromuse and Aspen Technology, sell “point solutions” that compete with our expert operations management products with respect to specific applications or uses. Several companies, including Ilog S.A., Pavilion, and System Management Arts, offer expert operations management products with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. 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 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.

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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, 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.

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

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

We are developing a new software reasoning platform, TrueManage, that is designed for handheld computing devices and targeted at application markets not currently addressed by our G2 and G2-based products. We have also begun to develop 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 are experiencing rapid advancements in related technologies and applications. We anticipate that it will require significant funding to develop, launch, and build distribution channels for TrueManage and LifeVisor. Our strategy is to distribute these products through other companies that have significantly larger presence and scale in the targeted markets than we do. There can be no assurance that we will be able to successfully complete the development of TrueManage and LifeVisor, that we will be able to provide functionality that is accepted by the targeted markets, or that we will be able to build partnerships for profitable distribution of these products.

Our stockholders may face an illiquid market for the shares of our stock that they own.

On August 21, 2001, our stock was delisted from the NASDAQ National Market because we failed to meet the applicable listing standards. Our common stock currently trades on the OTC Bulletin Board. The delisting may negatively impact the liquidity of our common stock, not only in the number of shares that can be bought or sold, but also through delays in the timing of transactions and the reductions in potential security analyst and media coverage. This may reduce the demand for our common stock and its trading price. The delisting may also impair our ability to raise additional working capital.

Our common stock is subject to regulation as a “penny stock.” The Securities and Exchange Commission has adopted regulations that generally define “penny stock” to be any equity security that has a market price or exercise price of less than $5.00 per share, subject to certain exceptions. For transactions covered by the “penny stock” rules, broker-dealers must make a special suitability determination for the purchase of the securities and must have received the purchaser’s written consent to the transaction prior to the purchase.

Additionally, for any transaction involving a penny stock, unless exempt, the rules require the delivery, prior to the transaction, of a risk disclosure document mandated by the Securities and Exchange Commission relating to the penny stock market. The broker-dealer is also subject to additional sales practice requirements. The additional burdens imposed upon broker-dealers by these requirements may discourage broker-dealers from effecting transactions in our common stock and may limit the ability of purchasers in this offering to sell the common stock in the secondary market.

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ITEM 7A.    QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

Investment Portfolio

We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand deposit accounts we use instruments that meet high credit quality standards such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At December 31, 2003, substantially all of our funds were in demand deposit accounts and government securities.

Impact of Foreign Currency Rate Changes

Our contracts with our 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 statement of operations. 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.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA.

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

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

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

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

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GENSYM CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) AND COMPREHENSIVE INCOME (LOSS)