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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended September 30, 2004

OR

Commission File Number: 0-27696

GENSYM CORPORATION

(Exact name of registrant as specified in its charter)

52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)

Telephone Number (781) 265-7100

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:    Yes  x    No  ¨

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act)    Yes  ¨    No  x

As of November 15, 2004 there were 7,255,377 shares of the Registrant’s Common Stock outstanding.

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GENSYM CORPORATION

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. Consolidated Financial Statements

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share amounts)

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

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)

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

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

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

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Operations

We are a provider of operations management and expert systems software products and services. Our products emulate the reasoning of human experts, using process knowledge and often real-time data, and then, on the basis of such reasoning, make recommendations or take direct operational actions. Most applications of our products are in the areas of abnormal condition 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.

2. Basis of Presentation

We have prepared the unaudited consolidated financial statements included in this report pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements prepared for the full year in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations; nevertheless, our management believes that the disclosures in this report are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments (of a normal and recurring nature) that are necessary to present fairly our consolidated financial position as of September 30, 2004 and our results of operations and cash flows for the three- and nine- month periods ended September 30, 2004 and 2003. These consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003, filed with the SEC on March 30, 2004. The results of operations for interim periods are not necessarily indicative of the results of operations for the full year or any other interim period. Certain prior period amounts have been reclassified to conform to the current period presentation.

During the year ended December 31, 2003, we sustained a significant loss in the first half of the year. Based on these results, management affected a restructuring plan designed to return the Company to profitability by year’s end without sacrificing our significant engineering investments in a next generation of products. Previously, we had achieved operating and overall profitability as well as positive cash flows for the year ended December 31, 2002. We believe that our cash and cash equivalents and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least the next 12 months. Our ability to maintain growth and profitability in 2004 and beyond is dependent on market acceptance of our existing and next generation of G2 and G2-based products and related services and on renewal of maintenance contracts for customer support at near-current levels.

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.

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. Comprehensive Income (Loss )

The components of comprehensive income (loss) for the three- and nine-month periods ended September 30, 2004 and 2003 are as follows (in thousands):

4. Net Income (Loss) Per Share

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

Options to purchase 232,709 shares of common stock with an exercise price between $2.03 and $10.00 per share were outstanding in the third quarter of 2004, and options to purchase 587,709 shares of common stock with an exercise price between $1.52 and $10.00 per share were outstanding in the nine-month period ended September 30, 2004. These were excluded from the computation of diluted earnings per share because such options were anti-dilutive in the respective periods since their exercise prices exceeded the market value of our common stock. All options to purchase a total of 1,401,619 shares of common stock were outstanding for each of the three- and nine- month periods ended September 30, 2003, but were excluded from the computation of diluted earnings per share because such options were anti-dilutive as we had net losses in those periods.

5. Stock Based Compensation

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

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

6. Segment Reporting

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

Revenues from one customer represented 10% and 13% of total revenues for the three- and nine- months ended September 30, 2004.

The following table presents our long-lived assets, net of depreciation and amortization, as of September 30, 2004 and December 31, 2003 (in thousands):

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

7. Employee Stock Purchase Plan

Our 1995 Employee Stock Purchase Plan (the “Purchase Plan”) was adopted by our Board of Directors in November 1995 and approved by our stockholders in January 1996. The Purchase Plan authorized the sale of common stock to participating employees. As of December 31, 2003, the number of shares of common stock reserved for issuance under the Purchase Plan was 1,200,000.

All of our employees meeting certain eligibility requirements were able to participate in the Purchase Plan. An employee could elect to have a whole number percentage from 1% to 10% of his or her base pay withheld during a payroll deduction period, known as an “Offering Period,” for purposes of purchasing shares under the Purchase Plan. The price at which shares could be purchased during each offering was 85% of the fair market value per share of our common stock on either the first day or the last day of the Offering Period, whichever was lower. Each of the Offering Periods was six months long. However, the Compensation Committee of the board of directors could, at its discretion, choose an offering period of 12 months or less for each of the offerings and choose a different Offering Period for each offering. Under the Purchase Plan, we sold 1,159,603 shares as of September 30, 2004, of which 54,036 and 173,287 were issued in 2004 and 2003, respectively.

Effective June 15, 2004, our Board of Directors voted to discontinue the Purchase Plan.

8. Guarantor Arrangements

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

The following is a summary of the agreements that we have determined are within the scope of FIN No. 45:

As permitted under Delaware law, we have agreements whereby we will indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, our liability for these agreements as of September 30, 2004 is not material.

We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we believe our liabilities recorded for these agreements as of September 30, 2004 are not material.

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

9. Restructuring Charges

In June 2003, our board of directors approved a workforce reduction plan to reduce our expenses to a level commensurate with then current levels of revenue. In accordance with this plan, we recorded a restructuring charge of $250,000 in June 2003, which was later adjusted to $216,000 during the fourth quarter of 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. Substantially all of the restructuring charges were paid as of June 30, 2004.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

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

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 17,700 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 G2 version 7.1 in December 2003, adding to G2’s integration capabilities with support for message-oriented middleware and other capabilities. In June 2004, we released G2 version 8.0, which represents a generational advance in our G2 product line, with major new capabilities for reasoning, integration, embeddability, user interfaces, and developer productivity.

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 developing 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.

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

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Prices for our products are generally denominated in U.S. dollars or Euros. 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.

Critical Accounting Policies

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

For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2003. Our critical accounting policies, as detailed in our Form 10-K for the year ended December 31, 2003, have not changed during the nine-month period ended September 30, 2004.

Results of Operations

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

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Revenues

Three and Nine months ended September 30, 2004 and 2003

Revenues

We derive revenue from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products, which include G2 and related application software. Services revenues consist of fees for support and maintenance, which is generally provided on an annual contract basis; consulting services; and training courses related to our products.

Total revenues for the three-month period ended September 30, 2004 were $4.4 million, an increase of $.5 million, or 14%, from the same period in 2003. The increase was attributable to an increase of $.3 million, or 27%, in license revenue and an increase of $.2 million, or 8%, in services revenue. Total revenues for the nine-month period ended September 30, 2004 were $12.9 million, an increase of $2.2 million, or 21%, from the same period in 2003. The increase was attributable to an increase of $2.1 million, or 64%, in license revenue and an increase of $.1 million, or 1%, in services revenue.

International revenues represented 53% and 52% of our total revenues for the three-month periods ended September 30, 2004 and 2003, respectively. This increase is a result of the completion of a large long term contract offset by a decrease in international consulting revenue. International revenues represented 51% and 53% of our total revenues for the nine-month periods ended September 30, 2004 and 2003, respectively. The decrease is the result of a general increase in sales in the US and a decrease in services internationally, partially offset by the recognition of revenue for a large, long term, international contract in the third quarter of 2004.

We currently have one customer that accounts for 10% and 13% of revenue for the three- and nine-month periods ended September 30, 2004, respectively.

Product. Product revenues for the three-month period ended September 30, 2004 were $1.6 million, an increase of $.3 million, or 27%, from the same period in 2003. This increase was due to the overall improvement of license sales. Product revenues for the nine-month period ended September 30, 2004 were $5.4 million, an increase of $2.1 million, or 64%, from the same period in 2003. This increase is mainly attributable to a large order received through a US government prime contractor and recognized in the second quarter of 2004.

Services. Services revenues for the three-month period ended September 30, 2004 were $2.8 million, an increase of $.2 million, or 8%, from the same period in 2003. This increase was a result of the increase in US services revenue, the recognition of revenues previously deferred on a large international order that was completed in the three-month period ended September 30, 2004, partially offset by the decrease in maintenance services and ongoing international services. Services revenues for the nine-month period ended September 30, 2004 were $7.5 million, an increase of $.1 million, or 1%, from the same period in 2003. This increase was due to an increase in consulting and educational services revenues of $.6 million, or 35% offset by a decrease in customer support revenues of $.5 million.

Cost of Revenues

Cost of revenues primarily consists of consulting labor, technical support costs, and the costs of material and labor involved in producing and distributing our software. These costs for the three-month period ended September 30, 2004 were $1.4 million, an increase of $.3 million, or 26%, from the same period in 2003. This increase was primarily due to additional subcontractor costs and the recognition of deferred work in progress charges for a completed contract, offset by the results of cost containment efforts. Our gross margin percentage decreased to 68% for the three-month period ended September 30, 2004 from 71% for the same period in 2003 as a result of smaller margins on sales that required subcontractor services. Cost of revenues for the nine-month period ended September 30, 2004 was $3.6 million, an increase of $.8 million, or 27%, from the same period in 2003. The reasons for the increase are the same as those

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pertaining to the quarter recently completed. Our gross margin decreased to 72% for the nine-month period ended September 30, 2004 from 73% for the same period in 2003 primarily due to the smaller margins on sales required subcontractor services.

Product. Product cost of revenues for the three-month period ended September 30, 2004 was $.1 million, a decrease of $.1 million, or 56%, from the same period in 2003. This decrease was primarily due to a reduction of costs required to support product services, commissions and royalties. Product cost of revenues for the nine-month period ended September 30, 2004 was $.6 million, unchanged from the same cost as the same period in 2003. This was a result of additional subcontractor and amortization costs in 2004 that were offset by cost containment efforts for the same period.

Services. Services cost of revenues for the three-month period ended September 30, 2004 was $1.3 million, an increase of $.4 million, or 49%, from the same period in 2003. The increase in service cost was primarily due to additional subcontracting and the recognition of work in progress costs previously deferred. . Services cost of revenues for the nine-month period ended September 30, 2004 was $3.0 million, an increase of $.8 million, or 34%, from the same period in 2003. The increase in service costs was primarily due to the same reasons as those pertaining to the quarter recently completed.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising, and promotional materials. These expenses for the three-month period ended September 30, 2004 were $1.1 million, a decrease of $.1 million, or 10%, from the same period in 2003. The decrease was primarily attributable to a decrease in sales personnel costs and their related travel costs resulting from the cost control program implemented in September 2003 partially offset by new marketing programs in 2004. Sales and marketing expenses for the nine-month period ended September 30, 2004 were $3.2 million, a decrease of $1.1 million, or 25%, from the same period in 2003. The decrease in sales and marketing costs was primarily due to the same reasons as those pertaining to the quarter recently completed. Sales and marketing expenses for the three-month period ended September 30, 2004 decreased to 24% of revenues from 31% for the same period in 2003. The decrease in percent of revenue was the result of an increase in product revenues and a decrease in expenses. Sales and marketing expenses for the nine-month period ended September 30, 2004 decreased to 25% of revenues from 40% for the same period in 2004. The decrease in percent of revenues was not a result of the decrease in actual expenditures but the result of the increase in revenues that form the basis for the calculation.

Research and Development. Research and development expenses consist primarily of costs of personnel, equipment and facilities. Research and development expenditures include ongoing enhancements of the existing G2 and G2 based product line, as well as new software products. These expenses for the three-month period ended September 30, 2004 were $.8 million which reflects a decrease of $47,000, or 5%, from the same period in 2003. This decrease is primarily attributable to cost containment measures, such as the reduction of costs related excess facility space and the reduction of depreciation expenses as capital equipment reached the end of the depreciation lifecycle. Research and development expenses for the nine-month period ended September 30, 2004 were $2.6 million, which was unchanged from the same period in 2003. This was a result of cost containment measures offset by additional personnel costs. Research and development expenses for the three-month period ended September 30, 2004 decreased to 19% of revenues from 22% for the same period in 2003. The decrease in percent of revenue was primarily the result of the decrease of overall spending in 2004. Research and development expenses for the nine-month period ended September 30, 2004 decreased to 20% of revenues from 24% for the same period in 2003. The decrease in percent of revenue was primarily the result of an increase in product revenues.

General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations and general management, as well as legal and accounting expenses. These expenses for the three-month period ended September 30, 2004 were $1.0 million, a decrease of $.2 million, or 20%, from the same period in 2003. The decrease was mainly attributable to lower professional service costs, personnel costs, and a reduction of the reserve for bad debts, partially offset by recruiting fees for senior management. General and administrative expenses for the nine-month period ended September

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30, 2004 were $2.9 million, a decrease of $.1 million, or 3%, from the same period in 2003. The decrease was mainly attributable to the reduction of our reserve for bad debt which was established in 2003, partially offset by an increase in recruiting costs and personnel expense. General and administrative expenses for the three-month period ended September 30, 2004 decreased to 22% of revenues from 31% for the same period in 2003. The decrease was mainly attributable to reduction of actual expenditures and the impact of increasing the revenues, which is the basis of the calculation. General and administrative expenses for the nine-month period ended September 30, 2004 decreased to 23% of revenues from 28% for the same period in 2003. The decrease was not a result of a decrease in actual expenditures and is mainly attributable to the increase in revenues.

Restructuring. In June 2003, our board of directors approved a workforce reduction plan to reduce our expenses to a level that was commensurate with then current levels of revenue. As a result of implementation of this plan, we recorded a pre-tax restructuring charge of $250,000 in June 2003, which was later adjusted to $216,000 during the fourth quarter of 2003. The charge is based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe and related legal costs. No costs were incurred prior to June 30, 2003, and the plan was completed by June 30, 2004 and there were no expenses in the third quarter of 2004. We paid $131,000 of restructuring expenses for the nine-month period ended September 30, 2004.

Other income, net. Other income (expense), net consists primarily of interest income and expense, realized gains or losses on foreign exchange transactions, and translation adjustments charged to income or expense. Other expense, net for the three-month period ended September 30, 2004 was $.1 million, compared to other income, net of $.2 million for the same period in 2003. The current other expense is primarily due to foreign exchange rate losses due to the continued weakening of the US dollar. Other expense, net for the nine-month period ended September 30, 2004 was $.2 million, compared to other income of $.3 million for the same period in 2003. The decreast was primarily due to the same reasons as those pertaining to the quarter recently completed.

Income Taxes. Our provision for income taxes pertains to foreign withholding tax and income taxes in the U.S. and foreign jurisdictions where our wholly owned subsidiaries have taxable income but do not have operating loss carry forwards. The recorded benefit for income taxes for the three-month period ended September 30, 2004 of $.68,000, compared to $16,000 for the same period in 2003. The tax benefit recorded in the three months ended September 30, 2004 is due to a reduction of our estimated tax obligations in the United States based on final 2003 tax filings completed during the three months ended September 30, 2004. The benefit for income taxes for the nine-month period ended September 30, 2004 was $24,000, compared with a provision of $195,000 for the same period in 2003. The decrease in the tax provision for the nine months ended September 30, 2004 is due to a reduction of United States tax obligation offset by obligations in certain foreign jurisdictions where we had income for the nine months ended September 30, 2003.

LIQUIDITY AND CAPITAL RESOURCES

Our September 30, 2004 cash and cash equivalents were approximately $3.0 million, an increase of $1.2 million from $1.8 million at December 31, 2003. Net cash provided by operating activities for the nine-month period ended September 30, 2004 was $1.1 million. Specifically, we had a net income of $.4 million, net of non-cash expenses of $.5 million (depreciation and amortization, loss on disposal of equipment, non-cash compensation, provision of bad debt), $1.4 million in cash received from accounts receivable and a $.4 million increase in accounts payable offset by an increase of $.1 million in prepaid expenses and other assets, and decreases of $.5 million in deposits and other assets (bonds held to ensure contract performance and work in progress for completed contracts), $.5 million in accrued expenses and $1.3 million in deferred revenue.

Cash used in investing activities for the purchase of property and equipment for the nine-month period ended September 30, 2004, was $32,000.

Cash used in financing activities for the nine-month period ended September 30, 2004, was $7,000, composed of $73,000 in payments under capital leases partially offset by $66,000 in proceeds from exercise of stock options and issuance of common stock under stock plans.

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

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.

Commitments and Contingencies

Leases

We lease our facilities and certain equipment under operating and capital leases. The future minimum annual payments under these leases at September 30, 2004 are as follows:

Stock Repurchase Program

In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of September 30, 2004, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2004 or 2003. During the three months ended September 30, 2004 and 2003, respectively, we reissued 5,287 and 19,775 shares of common stock to non-employee directors and a consultant. During the nine months ended September 30, 2004, and 2003, respectively, we reissued 14,965 and 57,287 shares of common stock to non-employee directors and a consultant. As of September 30, 2004, 369,319 shares remained in treasury at a cost of $1,374,000.

Related party transaction

On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving three employees who continue to work

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for us. The agreement calls for the payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. We made no payments to Integration Objects during the three months ended September 30, 2004. During the nine-month period ended September 30, 2004, we paid Integration Objects a total of $71,000.

Factors That May Affect Future Results

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

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

We incurred operating losses for two out of the three years ended 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 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 and the first, second and third quarters of 2004. 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 maintain our profitability.

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

We rely on maintenance contract renewals for a significant percentage of our revenue, as software maintenance fees have become a large 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. Software maintenance fees represented 42% of our total revenues for each of the three- and nine- months ended September 30, 2004. 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. For the three- and nine- months ended September 30, 2004, sales through such channel partners represented 45% and 52% of our product revenues, 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.

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We depend heavily on our sales and marketing force.

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

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

We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly or annual basis in the future. Our sales cycle typically ranges from 6 to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of significant orders could contribute to this quarterly variability. In addition, we ship software products within a short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarter’s revenues from software licenses have 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

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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 if we develop new technology and it is not accepted by the market.

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 53% and 52% of our total revenues for the three months ended September 30, 2004 and 2003, respectively. Our international revenues represented 51% and 53% of our total revenues for the nine months ended September 30, 2004 and 2003, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating documentation into local languages, fluctuations in the value of international currencies including the Euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, 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,

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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.

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.

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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.

ITEM 3. Qualitative and Quantitative Disclosures About Market Risk

Investment Portfolio

We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand deposit accounts we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At September 30, 2004, substantially all of our funds were in demand deposit accounts.

Impact of Foreign Currency Rate Changes

Our contracts with customers are generally denominated in US 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.

ITEM 4. Controls and Procedures.

Our management, with the participation of our chief executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2004. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2004, as a result of the material weaknesses in our internal controls over financial reporting described below, our disclosure controls and procedures were not effective to ensure that

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information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

During, and shortly following, the fiscal quarter ended June 30, 2003, we experienced turnover in our accounting and finance organization. In particular, our corporate controller left our company, and our European controller was on a personal leave of absence beginning in June 2003, returned to full-time status in October 2003, and was on personal leave again from April 2004 through the present. Furthermore, our former chief financial officer left our company in early August 2003. Management determined that the loss, or temporary absence of, these personnel resulted in certain conditions which, when considered collectively, constitute a material weakness in our internal controls. Such conditions included:

In addition to these weaknesses, our former independent auditors, PricewaterhouseCoopers LLP, identified certain other matters representing material weaknesses in internal controls over financial reporting in connection with their audit of our financial statements for the year ended December 31, 2003. These items included:

Beginning in the quarter ended September 30, 2003 we took a number of corrective actions to address the material weaknesses discussed above, including:

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We have performed additional procedures to evaluate the extent to which the internal control weaknesses discussed above could have led to material misstatements in our consolidated financial statements. Based on our evaluation, we do not believe that the control weaknesses and deficiencies noted above led to any material misstatements in the consolidated financial statements included in this report.

In addition, we implemented changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. These changes include:

We continue to evaluate our intercompany borrowing arrangements and intend to establish policies and procedures to evidence the accounting for intercompany borrowings. We are also continuing the process of establishing remote access for all of our bank accounts and adding our chief financial officer and chief executive officer as signatories to all of our bank accounts.

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PART II. OTHER INFORMATION

Item 2. Unregistered Sales of Securities, and Use of Proceeds

The following table provides information about purchases by the company during the quarter ended September 30, 2004 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:

GENSYM PURCHASES OF EQUITY SECURITIES¹

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ITEM 6. Exhibits

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

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SIGNATURES

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

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EXHIBIT INDEX

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