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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark one)

For the fiscal year ended December 31, 2004

OR

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:    Yes  x    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.  x

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

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, 2004, of $7,476,426.

As of March 29, 2004 there were 7,266,187 shares of the Registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement for the 2005 Annual Meeting of Stockholders to be held on Wednesday, May 18, 2004 are incorporated by reference into Part III of this Form 10-K.

PART I

ITEM 1.    BUSINESS.

General

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

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

Our key product is G2, a mature and robust software platform that underlies all of our other products. We released our most recent version of G2, version 8.0, in June, 2004. This release represented a generational advance in our G2 product line and introduced major new capabilities in the areas of reasoning technology, standards-based integration and embeddability, user interface, and developer productivity. G2 8.0 was designed to enable smooth migration of applications running in earlier versions of G2. We have begun field testing a pre-release version of G2 8.1.

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

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.

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

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

Our sales activities have historically involved a combination of direct sales to end users and indirect sales through partners. In January 2005, we launched an indirect channel strategy for our sales force that places their primary focus on development of new business through indirect channels. In addition, our sales force will continue to support the current and future needs of our existing end user customers. As part of the execution of our indirect channel strategy, we have introduced new indirect channel programs designed to improve our ability to attract new partners and to support existing partners, which pursue business based on our products across our target vertical markets. Channel partners are also able to provide development, support, and training services to our customers. We have channel partners in North and South America, Europe, the Middle East, Africa, and the Asian-Pacific region.

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 using rule-based knowledge and often real-time data. We sell G2 and several 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, rule engine applications that help improve complex business operations in real time. G2 applications apply 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

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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, rule-based applications without the need for conventional computer programming.

G2 enables an application developer to express rule logic through objects, rules, models and procedures using structured natural language so that the logic 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. Application changes in G2 are immediate, with no stopping for code compilation, and interactive to facilitate application improvements during prototyping, during development, and even while 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, often within a few days.

With G2, an application developer can model a process in terms of interrelated objects, which may be in graphical or schematic diagram form. These 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 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 operating systems, 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 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 end users to share that application concurrently. Telewindows and G2 WebLink are available on all G2 platforms as well as on PCs running Windows.

In June 2004, we released G2 version 8.0. This release represented a generation advance in G2 and contained important new functionality, including:

In February 2005, we began field testing a pre-release version of G2 8.1., which, when commercially released, is expected to include new capabilities that enhance G2’s representation and processing of rule logic and that further increase the productivity of application developers.

G2 NeurOn-Line

G2 NeurOn-Line is a G2-based software product 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 manufacturing process conditions. G2 NeurOn-Line can identify and generate models of the physical behavior of processes and of relationships among process variables, when given

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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 G2 NeurOn-Line are built graphically by selecting objects from menus, connecting them, and entering attribute and control information. Bundled with G2 NeurOn-Line is NeurOn-Line Studio, which 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 it 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.

G2 Optegrity

G2 Optegrity is a G2-based software product that enables process manufacturers to manage abnormal conditions that occur within process plants. G2 Optegrity ensures sustained operational performance and continuous availability of production assets. Its applications detect and resolve abnormal process conditions early, before the conditions would otherwise be detected by operators or control systems and before they escalate to disrupt production and threaten quality and profits. G2 Optegrity 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.

Included with G2 Optegrity are Intelligent Objects which are G2-based software objects that proactively detect problematic 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. The objects are highly configurable to save time and cut effort in building and maintaining G2 Optegrity applications.

G2 Integrity

G2 Integrity is an integrated G2-based software product for intelligently managing faults and service levels in voice and data networks. G2 Integrity maintains continuous availability by detecting, diagnosing and correcting problems before they adversely impact 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 G2 Integrity to manage the performance of many different types of networks. G2 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 G2 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.

G2 ReThink

G2 ReThink is a software platform for graphical simulation, analysis, and automation of business processes. As a simulation and analysis tool, G2 ReThink enables users to model their business operation and rule-based policies 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 and policy alternatives. Unlike other simulation tools, G2 ReThink can deploy models and rules to monitor and automate the execution of business processes. G2 ReThink applications can monitor business processes in real time, alerting operations personnel to potential problems as they occur. By automating the online execution of business processes, G2 ReThink can help achieve sustained performance.

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G2 e-SCOR

G2 e-SCOR is a G2-based product for supporting supply-chain design and policy decisions. Based on the Supply Chain Council’s SCOR standard, G2 e-SCOR drives strategic decisions by evaluating and comparing alternative supply-chain designs and management strategies. With G2 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. G2 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 manufacturing sector, customers include firms such as ABB, Dow Chemical, DuPont, Eli Lilly, El Paso Energy, Emerson, Exxon Mobil, 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 telecommunications sector, our customers include Computer Sciences Corporation, Ericsson, Motorola, and Pivetal.

Manufacturing has been a 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 through our own consulting organization, our customers deploy custom applications based on our products.

Our sales force operates across markets servicing both end users and partners. In January 2005, we launched new indirect channel programs and redirected the primary focus of our sales force to grow new business through our indirect channel partners. Our new indirect programs are designed to leverage the market presence, domain knowledge, and project experience of our partners. At the same time, our sales force will continue to directly support the current and future needs of our existing base of end users.

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 sales offices in the U.S., Europe, and the Middle East, and channel partners worldwide. In 2004, 2003, and 2002 we received 50%, 54%, and 57% of our total revenues, respectively, from international operations. Our domestic and international sales as a percentage of total revenues in 2004, 2003, and 2002 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. 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. Our channel partners, who include systems integrators, original equipment

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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, Ericsson, Invensys, MinnovEx, and Siemens. Our direct sales efforts and our channel partners generated the following percentages of product revenues for 2004, 2003, and 2002 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 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, South America 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 a progressive series of 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.

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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, was held in Nice, France in October 2004. During 2005, we plan to hold user society meetings at regional locations.

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 2004, we released new versions of our products to address new market requirements and update existing program code. In June, 2004 we released G2 version 8.0, which represented a generational advance and was designed to reduce the time and effort it takes to develop and deploy G2 applications and to enhance application benefits. G2 8.0 contains many new features, including a new publish and subscribe capability to enhance detection of real time events, extended support of Microsoft Windows standards to improve embeddability of G2, and many features that reduce application development effort. In February 2005, we began field testing a pre-release version of G2 8.1 which, when commercially released, is expected to include capabilities that enhance G2’s representation and processing of rule logic and that further increase the productivity of application developers.

In 2004, approximately 28% 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 as follows for the years ended 2004, 2003 and 2002 respectively:

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.

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The first TrueManage application expected to reach the market is LifeVisor^™, a cell phone based device for self management of chronic diseases, such as diabetes and obesity. When development is completed, LifeVisor is expected to provide around-the-clock, proactive, intelligent guidance for a patient’s daily activities, such as checking blood glucose levels, taking medication, eating meals, and exercising. LifeVisor is also expected to be able to interface between a patient and his or her care providers.

Competition

We face competition from other rule engine vendors and from application-specific vendors. Rule engines have their roots in artificial intelligence technology and expert system software. The rule engine market is one that has evolved during the past several years into a widely recognized category of information technology. For example, prominent IT analyst organizations, such as Gartner, Inc., now regularly publish reports on business rule engine technology and vendors.

In the rule engine market, Gensym’s G2 competes with other established rule engine products including Fair Isaac’s Blaze product, ILOG’s Rules product, and Computer Associates’ Aion product. We believe that G2 differentiates itself from these and other rule engine products by its ability to apply rule logic in real time. G2 addresses what Gensym sees as one of the toughest challenges in rules processing—the ability to optimally process large numbers of transactions using complex decision logic in real time. G2 is designed to meet this challenge with scalability and to enable agile responses to changing operating conditions by allowing users to easily make ‘on-the-fly’ updates to the decision logic. We believe that there is a growing need in the rule engine market for these capabilities.

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 rule-driven management solutions. Competition in these 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 and Pavilion sell solutions that compete with our products with respect to specific applications or uses. A rule-driven 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 rule logic and other reasoning technologies, such as neural networks.

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. There is no assurance that our market position or competitive advantages will continue. See “Factors That May Affect Future Results.”

Proprietary Rights

Our success and ability to compete are dependent to a significant degree on our ability to develop and maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. We rely on a combination of patent, trademark, trade secret and copyright laws and licenses and contractual restrictions to protect the proprietary aspects of our technology. These legal protections afford only

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limited protection for our technology. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to license agreements, which impose restrictions on the licensee’s ability to utilize the software. In addition, we seek to limit disclosure of our intellectual property by requiring employees, consultants and customers with access to our proprietary information to execute confidentiality agreements with us. We also restrict access to our source code. Due to rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments and enhancements to existing products are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.

We have filed patent applications on two inventions embodied in our new software reasoning platform, TrueManage. There can be no assurance that any of these applications will result in an issued patent.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult and, while we are unable to determine the extent to which piracy of our software exists, it can be expected to be a persistent problem. In addition, the laws of many countries do not protect our proprietary rights to as great an extent as do United States laws. Litigation may be necessary in the future to enforce our intellectual property rights, protect our trade secrets, determine the validity and scope of the proprietary rights of others or defend against claims of infringement or invalidity. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology. Any failure by us to meaningfully protect our intellectual property could have a material adverse effect on our business, operating results and financial condition.

There can be no assurance that other parties will not claim infringement with respect to our current or future products. We expect that developers of rule engine software products increasingly will be subject to infringement claims as the number of products and competitors in our industry segment grows and as the functionality of products in different segments of the software industry increasingly overlaps. Any such claims, with or without merit, could be time consuming to defend, result in costly litigation, divert management’s attention and resources, cause product shipment delays or require us to enter into terms marginally acceptable to us. A successful infringement claim against us and our failure or inability to license the infringed rights or develop or license technology with comparable functionality could have a material adverse effect on our business, financial condition and operating results.

We integrate certain technology licensed from third-parties into our products. This third-party technology may not continue to be available on commercially reasonable terms. We believe there are alternative sources for such technology. However, if we are unable to maintain licenses to the third-party technology included in our products, product distribution could be delayed until equivalent software could be developed or licensed and integrated into our products. This delay could materially adversely affect our business, operating results 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.

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Employees

As of December 31, 2004, we had 79 employees, including employees in the following functional areas:

Of these employees, 57 were located in the United States and 22 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, 2004, 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.

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

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. Prices for common stock are the closing sales prices 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 124 holders of record of our common stock as of February 7, 2005. 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 2005 Annual Meeting of Stockholders to be held on May 18, 2005 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.

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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

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. While we may elect to update forward looking statements in the future, 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 operations management applications that are based on rule-driven, real-time logic. Our flagship product has been, and continues to be, G2, which applies the rule-based knowledge of human experts to support and automate decisions that optimize operations and that detect, diagnose, and resolve costly problems. 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 8.0, in June 2004, which constituted a generational advance in our product. We have begun field testing a pre-release version of G2 8.1.

In January 2005, we refocused our sales force on generation of new business primarily through indirect channels. However, our sales force will continue to support the current and future needs of our existing end user customers. As part of the execution of our indirect channel strategy, we have introduced new indirect channel programs designed to improve our ability to attract new partners and to support existing partners, which pursue new business based on our products across all of the vertical and horizontal markets that we serve.

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. In 2004, approximately 42% of our revenues were generated from license sales, 17% from consulting and training and 41% 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.

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.

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Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 104, Revenue Recognition (SAB 104), 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.

For software license arrangements that do not require significant modification or customization of the underlying software, we recognize license revenue when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred (FOB shipping point or electronic distribution); (3) the fee is deemed fixed or determinable; and (4) collection is probable. Substantially all of our license revenues are recognized in this manner.

Our software is distributed directly through our sales force and indirectly through alliances with resellers. Revenue arrangements with resellers are recognized upon delivery of the software to the reseller provided all other revenue recognition criteria, as specified above, have been satisfied. We historically have not offered resellers contractual rights of return, stock balancing, or price protection.

We assess whether fees are fixed or determinable and free of contingencies or significant uncertainties at the time of sale and recognize revenue if all other revenue recognition criteria are met. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.

Our license arrangements generally do not include acceptance provisions. However, if an arrangement includes an acceptance provision, revenue is recognized upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

Our software arrangements may include consulting services sold separately under consulting engagement contracts that generally include implementation. These services may also be provided completely or partially by independent third-parties experienced in providing such consulting and implementation in coordination with dedicated customer personnel. Revenues from these arrangements are generally accounted for separately from the license revenue because they meet the criteria for separate accounting, as defined in SOP 97-2. The more significant factors considered in determining whether the revenue should be accounted for separately include the nature of services, such as consideration of whether the services are essential to the functionality of the licensed product, degree of risk, availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on the realizability of the software license fee.

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We account for software license revenues included in multiple element arrangements using the residual method prescribed in SOP 98-9. Under the residual method, the fair value of the undelivered elements, such as maintenance, consulting, and education services, based on vendor specific objective evidence is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements, such as software license. If evidence of the fair value of one or more of the undelivered services does not exist, revenues are deferred and recognized when delivery of those services occurs or fair value can be established. We determine vendor specific objective evidence of fair value for services revenues based upon our current pricing for those services when sold separately and vendor specific objective evidence of fair value for maintenance services is measured by substantive renewal rates. Our current pricing practices are influenced primarily by product type, purchase volume, maintenance term, and customer location.

Maintenance services generally include rights to unspecified upgrades, when and if available, telephone support, updates, and bug fixes. Maintenance revenue is recognized ratably over the term of the maintenance contract on a straight-line basis when all the revenue recognition requirements are met. Historically we have not offered any specified upgrade rights to an existing product.

Consulting revenues are generally recognized as the services are performed on a time and materials basis. Consulting revenues for fixed-price contracts are recognized using the percentage-of-completion basis. If there is a significant uncertainty about the project completion or receipt of payment for the consulting services, revenue is deferred until the uncertainty is sufficiently resolved.

Education revenues are recognized as the related training services are provided.

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.

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. Foreign currency exchange gains and loses on our trade accounts receivable are recorded as a component of other income (expense).

In 2004 we evaluated our intercompany balances and based upon our determination that settlement of such balances would not be planned or anticipated for the foreseeable future, we entered into formal long-term note agreements with our subsidiaries. As a result, we account for such notes as part of our net investment in these subsidiaries and accordingly record foreign currency changes related to these balances as a component of accumulated other comprehensive income.

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.

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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 carry forwards, 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 due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of certain net operating loss carry forwards 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, 2004, we continued to have a 100% valuation allowance against our deferred tax assets.

We have taken the position under Accounting Principles Board Opinion No. 23, Accounting for Income Taxes—Special Areas, that all earnings of our foreign subsidiaries are permanently re-invested. 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 33 of this Annual Report on Form 10-K which contain accounting policies and other disclosures required by accounting principles generally accepted in the United States.

Results of Operations

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

In 2003, we recognized a restructuring charge of $216,000.

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

Years Ended December 31, 2004 Compared with Year Ended December 31, 2003

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 $17.6 million for the year ended December 31, 2004 as compared to $14.6 million for the same period in 2003, an increase of $3.0 million, or 21%. The increase in revenue is attributable to an

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increase of $2.6 million, or 55%, in product revenues and an increase of $0.4 million, or 4%, in service revenues. Product revenues increased mainly due to several large government contracts entered into in the second and fourth quarters of 2004. Service revenues increased primarily due to the recognition of revenue for a large, long term international contract that was completed in the third quarter of 2004 and was partially offset by a decline in maintenance revenues. International revenues accounted for 50% of total revenues in 2004 and 54% in 2003, while U.S. revenues accounted for 50% and 46% in 2004 and 2003, respectively.

Product.    Product revenues increased by $2.6 million, or 56%, to $7.3 million for the year ended December 31, 2004 from $4.7 million in 2003. Europe product revenue was $2.9 million, or 39% of total product revenue in 2004, and $1.8 million, or 39% of total product revenue in 2003. Product revenues in Europe increased due to increase demand from the telecommunication and pharmaceutical industries. U.S. product revenues increased from 2004 to 2003 as a result of several large government contracts.

Services.    Service revenues increased $0.4 million, or 4%, to $10.3 million for the year ended December 31, 2004 from $9.9 million in 2003. Maintenance revenues decreased $0.6 million, or 8%, to $7.2 million in 2004 compared to $7.8 million in 2003. The decrease in maintenance revenue was a result of several long term customers whose maintenance service agreements expired and were not renewed. Consulting revenues increased $0.9 million, or 52%, to $2.8 million in 2004 compared to $1.9 million in 2003. The increase in consulting revenues was due to the several large government contracts in the second and fourth quarters of 2004 as well as the recognition of revenue for a large, long term international contract that was completed in the third quarter of 2004. Training revenues increased 16%, to $0.3 million in 2004 compared to $0.2 million in 2003.

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 $4.9 million for the year ended December 31, 2004 as compared to $3.8 million for the same period in 2003, an increase of $1.1 million, or 29%. The increase in cost of revenues was primarily the result of increased personnel and subcontractor costs related to consulting projects, and the recognition of costs associated with the long term contract completed in 2004. The average number of employees associated with the cost of revenue was the same in 2003 and 2004 at 26 employees. There were 26 cost of revenue employees as of December 31, 2004.

Product cost was $0.7 million in 2004, unchanged from 2003. Although there was no change in overall expenditure, there was a increase of $.1 million in contractor license fee offset by a decrease $.1 million in facility costs due to reduced headcount in 2004. The average number of employees associated with product cost was three in 2003 and 2004. There were two product employees as of December 31, 2004.

Services cost was $4.2 million in 2004, an increase of $1.1 million, or 36%, from $3.1 million in 2003. The increase was primarily the result of a $0.4 million increase in contractor costs, $0.4 million in costs associated with a long term contract completed in 2004, $0.1 million increase in salary expense, and a $0.1 million increase in facility costs due to an additional number of employees in 2004. The average number of employees associated with service cost was 23 for 2003 and 2004. There were 24 service employees as of December 31, 2004.

Gross margin on revenues decreased from 74% in 2003 to 72% in 2004 due to the net change in revenue and cost of revenue described above.

Operating Expenses

Total operating expenses were $11.9 million in 2004 (67% of total revenues) as compared to $12.8 million (88% of revenues) in 2003; a decrease of $1.1 million, or 8%. Operating expenses for the year ended December 31, 2003 includes a $0.2 million restructuring charges. The decrease in operating expenses were primarily the result of a $0.7 million decrease in personnel costs, a $0.5 million decrease in accounting and legal fees, a $0.2 million reduction in severance fees, $0.2 million decrease in depreciation and amortization and $0.1 million decrease in bad

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debt expense, partially offset by a $.4 million increase in bonuses and commissions, a $0.2 million increase in marketing program costs, a $0.1 million increase in recruiting fees, and a $0.1 million increase in directors fees. The average number of employees associated with operating expenses decreased by eight from 2003 to an average of 53 employees in 2004. There were 53 operating employees as of December 31, 2004.

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, 2004, sales and marketing expenses decreased $1.0 million, or 17%, to $4.6 million (26% of total revenues) compared to $5.6 million (38% of total revenues) in 2003. The decrease in expenses was primarily the result of a $0.7 million decrease in personnel cost, $0.2 million reduction of travel costs, and $0.8 million decrease in facility costs as a result of the lower number of employees in 2004, partially offset by $0.2 million increase in commissions due to higher sales volume and $0.2 million of additional marketing expenditures. The average number of employees associated with sales and marketing decreased by seven from 2003 to an average of 16 employees in 2004. There were 16 sales and marketing employees as of December 31, 2004.

Research and Development.    Research and development expenses consist primarily of costs of personnel, equipment, and facilities. For the year ended December 31, 2004, research and development expenses remained at $3.3 million during 2004 and 2003 (19% of total revenue in 2004, 23% of total revenue in 2003) Although there was no change in overall expenditure, there was a increase of $.2 million in bonus costs as a result of increased company profitability, partially offset by a reduction in facility costs as a result of the lower number of employees in 2004. In addition, $.3 million of additional personnel costs were incurred on research and development related to G2, offset by a $.3 million decrease in personnel costs for TrueManage. The average number of employees associated with research and development decreased from 2003 by one to an average of 19 employees in 2004. There were 19 research and development employees as of December 31, 2004.

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 $0.2 million, or 7%, to $3.9 million (22% of total revenue) for the year ended December 31, 2004 compared to $3.7 million (25% of total revenue) in 2003. During 2003 we incurred significant accounting and legal fees due to the turnover of accounting personnel and compliance with new laws and regulations adopted by the SEC and Congress. Accounting and legal fees were reduced by $.5 million in 2004, depreciation decreased by $0.2 million, bad debt decreased by $0.1 million, which was offset by an increase in bonus expense of $0.3 million as a result of increased company profitability, additional recruiting fees of $0.1 million, additional facility fees of $0.4 million and additional board fees of $0.1 million. The average number of employees associated with general and administration remained unchanged from 2003 at 18 employees in 2004. There were 18 general and administrative employees as of December 31, 2004.

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. In accordance with this plan, we recorded a restructuring charge of $216,000 in the second 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. The reduction in employee headcount was from all operating groups and totaled 12. At December 31, 2004, all accrued restructuring costs had been paid.

Other Income (loss)

Other income (loss) consists primarily of foreign exchange transaction gains and losses, interest income and interest expense. For the year ended December 31, 2004, other income was $37,000, compared to $245,000 for the year ended December 31, 2003. We realized foreign exchange gains of $70,000 associated with invoices billed in US dollars and paid in euros that benefited from the strengthening of the Euro currency during 2004. This was offset by a $0.2 reduction in exchange gains in 2004 as compared to 2003, as intercompany transactions

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were reclassified as long term loans, resulting in unrealized exchange gains or loss reflected on the balance sheet as a component of accumulated other comprehensive income. This compared to combined exchange gains of $0.2 million in 2003. Interest income for the year ended December 31, 2004 remained unchanged from the year ended December 31, 2003, at $31,000. Interest expense for the year ended December 31, 2004 decreased $11,000, or 55%, to $11,000 compared to $21,000 in 2003.

Income Taxes

We recorded a provision for income taxes of $22,000 and $44,000 for the years ended December 31, 2004 and 2003, respectively. The tax provisions for 2004 and 2003 primarily represent taxes on income generated in certain foreign jurisdictions, where we do not have operating loss carry forwards available to reduce current taxes due.

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 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

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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 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

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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.

Liquidity and Capital Resources

Our December 31, 2004 cash and cash equivalents were $2.9 million an increase of $1.1 million from December 31, 2003. Cash provided in operations in 2004 was $0.8 million compared to cash used by operations of $1.9 million in 2003. Cash provided in operations in 2004 was primarily due to a net profit of $1.4 million, adjusted for non-cash changes(depreciation and amortization, loss on disposal of equipment, provision for bad debt and the non-cash portion of compensation). In addition, cash flows provided in operations were impacted by an increase of accounts payable and accrued expenses of $0.2 million, an increase of prepaid expenses and other assets of $0.1 million, and decreases in deferred revenue of $0.8 million and accounts receivable of $0.1 million.

Cash provided by investing activities in 2004 was $0.4 million compared to $0.4 million used by investing activities in 2003 and primarily consisted of $0.4 million provided by the reduction in work in progress related to a long term contract completed in 2004.

Cash provided by financing activities in 2004 was $5,000, which consisted of $94,000 of proceeds from the exercise of stock options and issuance of common stock under stock plans offset by $89,000 in principal payments on capital lease obligations.

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. We believe that our existing cash and cash equivalents and investments in marketable securities will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.

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Contractual Obligations

Our contractual obligations as of December 31, 2004 are as follows:

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 Rent, office lease, and equipment lease expense under the above leases, net of rental income from sub-leases, was approximately $1.2 million in 2004, $1.3 million in 2003, and $1.6 million in 2002.

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, 2004, a total of 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 2004, we reissued 24,943 shares with a weighted average fair value of $1.73 to non-employee directors and a consultant. 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, 2004, 364,269 shares remained in treasury at a cost of $1,358,723.

Related Party Transactions

On January 9, 2002 we entered into a three-year original equipment manufacturer agreement with Integration Objects Inc., a Tunisian corporation founded by 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 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 $99,000 and $162,000 during the years ended December 31, 2004 and 2003, respectively, under this agreement. At December 31, 2004, we had unpaid royalties to Integration Objects of $37,000. On March 25, 2005, this agreement was extended for six months.

In December 2004, the FASB issued SFAS No. 123(R), Share Based Payment. This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation” and APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. This statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services or incurs a liability in exchange for goods and services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. It requires an entity to measure the costs of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize that cost over the service period. This statement is effective for the first interim or annual period beginning after June 15, 2005. Accordingly, we will adopt its provisions effective July 1, 2005. The Company has not yet determined the impact that adoption of this statement will have on our consolidated financial position or results of operations. However, the proforma presentation included in the Stock-based Compensation section of Note 1 to our consolidated financial statements reflects what the impact of adopting this standard would have been on the historical periods presented.

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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-K or presented elsewhere by management form time to time.

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

Although we were profitable in 2004, we incurred operating losses in 2003 and for three of the five years ending December 31, 2004. 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. We incurred operating losses in each of the first three quarters of 2003 but achieved profitability in the fourth quarter of 2003. We were profitable for each quarter in 2004. As of December 31, 2004, our accumulated deficit was $19.2 million. 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 remain profitable and even if we do continue to achieve profitability, we cannot assure you that we can sustain or increase profitability on a quarterly or annual basis.

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 35%, 44% and 39% of our total revenues in the years ended December 31, 2004, 2003 and 2002, 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 49%, 56% and 52% of our product revenues in years ended December 31, 2004, 2003 and 2002, respectively. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing successful G2-based applications could have a material adverse effect on our business, results of operations, 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, our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel, and our ability to manage sales and channel partners. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the

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significantly more extensive and better funded sales and marketing operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, results of operations, cash flows, or financial position.

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

We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly or annual basis in the future. Our sales cycle typically ranges from 6 to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of significant orders could contribute to this quarterly variability. In addition, we ship software products within a short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarter’s revenues from software licenses has come from license contracts that have been executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these large orders is delayed, it could result in a substantial reduction in revenues for that quarter. Our expense levels are based in part on expectations of future revenue levels. A shortfall in expected revenues could therefore result in a disproportionate decrease in our results of operations and cash flows, which may impact our ability to continue as an independent concern.

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

Our international revenues represented 50%, 54%, and 57% of our total revenues for years ended December 31, 2004, 2003, and 2002, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating documentation into local languages, fluctuations in the value of international currencies including the Euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, cash flows, or financial position.

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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.

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

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

In addition, we believe that end users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than general software tools to develop application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are increasingly reliant on indirect channel partners, including original equipment manufacturers, value-added resellers, and systems integrators, to satisfy market requirements. A number of software companies offer products that compete in specific application areas addressed by these partners, such as cement kiln control, manufacturing execution systems, logistics systems, and network management, and they could be successful in supplying alternatives to products based on our software.

Companies offering competitive rule engine products include Fair Isaac, ILOG, and Computer Associates. Certain companies, such as Micromuse and Aspen Technology, sell “point solutions” that compete with operations management applications based on G2 with respect to specific applications or uses. Several companies, including ILOG., Pavilion, and System Management Arts, offer operations management products with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. Certain competitors in this category have greater financial and other resources than we do and might introduce new or improved products to compete with G2, possibly at lower prices.

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

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

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

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

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

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

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

We 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. There can be no assurance that we will be able to provide this level of funding internally. There can be no assurance that we will be able to raise additional funding externally at reasonable rates. Our strategy is to distribute these products, particularly LifeVisor, 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.

Managing our international operations is complex and our failure to do so successfully or in a cost-effective manner would have a material adverse effect on our business, operating results and financial condition

International sales accounted for 50%, 54% and 57% of our total revenues for the years ended December 31, 2004, 2003 and 2002, respectively. Our international operations require significant management attention and financial resources.

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

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These factors may have a material adverse effect on our future international sales and, consequently, on our business, operating results and financial condition.

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

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

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

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

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

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

Our common stock is quoted on the OTC Bulletin Board, which limits the liquidity and could negatively affect the value of our common stock.

Our common stock is quoted on the OTC Bulletin Board, which provides significantly less liquidity than a securities exchange, such as the American Stock Exchange, or an automated quotation system, such as the NASDAQ National or SmallCap Market.

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

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

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.

Changes to financial accounting standards could make it more expensive to issue stock options to employees, which will increase our compensation costs and may cause us to change our business practices.

We prepare our financial statements to conform to GAAP in the United States America. These accounting principles are subject to interpretation by the Public Company Accounting Oversight Board, the SEC and various other bodies. A change in those policies could have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. For example, we have used stock options and other long-term equity incentives as a component of our employee compensation packages. We believe that stock

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options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of vesting, encourage employees to remain with us. In December 2004, the Financial Accounting Standards Board issued a final standard that requires us to record a charge to earnings for the fair value employee stock option grants. This standard will be effective for interim and annual periods beginning after June 15, 2005. We could adopt the standard in one of two ways the modified prospective transition method or the modified retrospective transition method, and we have not concluded how we will adopt the new standard. In addition, regulations implemented by The NASDAQ National Market generally require stockholder approval for all stock option plans, which could make it more difficult or expensive for us to grant stock options to employees if we comply with such regulations. We will, as a result of these changes, incur increased compensation costs, which could be material and we may change our equity compensation strategy or find it difficult to attract, retain and motivate employees.

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

Our certificate of incorporation and bylaws contain provisions that may make a change of control of us difficult, even if it would be beneficial to our stockholders, including provisions governing the classification, nomination and removal of directors, prohibiting stockholder action by written consent and regulating the ability of our stockholders to bring matters for action before annual stockholder meetings, and the authorization given to our board of directors to issue and set the terms of preferred stock.

In addition, we have adopted a stockholder rights plan, which would cause extreme dilution to any person or group that attempts to acquire a significant interest in our company without advance approval of our board of directors, while Section 203 of the Delaware General Corporation Law would impose restrictions on mergers and other business combinations between us and any holder of 15 percent or more of our outstanding common stock.

ITEM 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, 2004, substantially all of our funds were in demand deposit accounts and government securities.

Impact of Foreign Currency Rate Changes

Our contracts with customers are generally denominated in U.S. dollars or Euros. For the year ended December 31, 2004, we incurred $70,000 in exchange rate fluctuations related in contracts with customers. We do not use foreign exchange forward contracts to hedge our foreign currency denominated receivables. There can be no assurance that changes in foreign currency rates, relative to the U.S. dollar, will not materially affect our consolidated results in the future.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA.

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

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

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)