Gensym 10Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended June 30, 2006

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

For the transition period from to .

Commission File Number: 0-27696

GENSYM CORPORATION

(Exact name of registrant as specified in its charter)

Delaware

04-2932756

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)

Telephone Number (781) 265-7100

(Registrant’s telephone number, including area code)

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

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

Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated filer x

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

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

INDEX


Explanatory Note		3

Part I—Financial Information

Item 1.	Consolidated Financial Statements

	Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005 (Unaudited)	5

	Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2006 and 2005 (Unaudited)	6

	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005 (Unaudited)	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19

Item 3.	Qualitative and Quantitative Disclosures About Market Risk	26

Item 4.	Controls and Procedures	26

Part II—Other Information

Item 1.	Legal Proceedings	28

Item 1A.	Risk Factors	28

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds.	35

Item 6.	Exhibits	36

	Signatures	36

	Exhibit Index	37

GENSYM CORPORATION

EXPLANATORY NOTE

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

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

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

•

revenue recognition for certain software license and service agreement transactions;

•

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

•

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

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

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

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

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

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

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

Cumulative Effect of Adjustments on Accumulated Deficit

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


	1999 and Prior			2000			2001			2002			2003			2004			2005			First Quarter of 2006
	As Restated (1) (in thousands)
Net (loss) income as originally reported	$	—		$	(12,816	)	$	(3,749	)	$	1,644		$	(1,783	)	$	894		$	(663	)	$	(575	)

Adjustments related to:
Revenue Recognition		(790	)		(1,335	)		1,331			(103	)		162			101			(579	)		99
Stock Compensation		(35	)		(120	)		(33	)		(14	)		(31	)		(15	)		6			—
Other Accounting Adjustments		—			—			—			—			204			(24	)		(24	)		3

Net adjustments		(825	)		(1,455	)		1,298			(117	)		335			62			(597	)		102

Net (loss) income as restated		(825	)		(14,271	)		(2,451	)		1,527			(1,448	)		956			(1,260	)		(473	)

Cumulative effect to Accumulated Deficit	$	825		$	2,280		$	982		$	1,099		$	764		$	702		$	1,299		$	1,197

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

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

•

Part I, Item 1, Note 3, “Restatement of Previously Issued Financial Statements;”

•

Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Restatement of Previously Issued Financial Statements;”

•

Part I, Item 4, “Controls and Procedures;” and

•

Part II, Item 1A, “Risk Factors.”

PART I. FINANCIAL INFORMATION

ITEM 1.

Consolidated Financial Statements

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share and per share amounts)


	June 30, 2006			December 31, 2005
				As Restated (1)
ASSETS
Current Assets:
Cash and cash equivalents	$	3,925		$	3,176
Accounts receivable, net of allowance for doubtful accounts of $42 at June 31, 2006 and $48 at December 31, 2005		3,272			3,987
Prepaid and other current assets		695			345

Total current assets		7,892			7,508

Property and equipment, net		636			599
Deposits and other assets		162			334

Total Assets	$	8,690		$	8,441


LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current Liabilities:
Accounts payable	$	449		$	495
Accrued expenses		1,772			1,541
Current portion of capital lease obligation		107			101
Deferred revenue		5,235			5,119

Total current liabilities		7,563			7,256

Capital lease and other long term liabilities, net of current portion		195			179
Long term deferred revenue		1,175			1,084

Total Liabilities		8,933			8,519

Commitments and contingencies
Stockholders’ Deficit:
Preferred stock $.01 par value-authorized 2,000,000 shares issued and out standing—none
Common stock $.01 par value—authorized—20,000,000 shares issued—7,803,356 and 7,773,222 shares in 2006 and 2005 respectively outstanding—7,470,987 and 7,429,541 shares in 2006 and 2005, respectively		78			78
Capital in excess of par value		22,549			22,372
Treasury stock—332,369 shares in 2006 and 343,681 shares in 2005 at cost respectively		(1,240	)		(1,282	)
Accumulated deficit		(21,616	)		(21,215	)
Accumulated other comprehensive income		(14	)		(31	)

Total stockholders’ deficit		(243	)		(78	)

Total liabilities and stockholders’ deficit	$	8,690		$	8,441

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

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

GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)


	Three Months Ended June 30,					Six Months Ended June 30,
	2006		2005			2006			2005
			As Restated (1)						As Restated (1)
Revenues:
Product	$	1,628	$	1,785		$	3,320		$	3,605
Services		2,824		2,888			5,020			5,760

Total revenues		4,452		4,673			8,340			9,365

Cost of revenues:
Product		96		106			227			255
Services		1,240		1,234			2,098			2,432

Total cost of revenues		1,336		1,340			2,325			2,687

Gross profit		3,116		3,333			6,015			6,678

Operating expenses:
Sales and marketing		1,113		1,302			2,417			2,709
Research and development		739		981			1,700			2,018
General and administrative		1,196		1,022			2,293			2,164

Total operating expenses		3,048		3,305			6,410			6,891

Operating income (loss)		68		28			(395	)		(213	)
Other income (expense), net		33		(7	)		25			(22	)

Income (loss) before provision for income taxes		101		21			(370	)		(235	)
Provision for income taxes		7		8			9			24

Net income (loss)	$	94	$	13		$	(379	)	$	(259	)
Basic earning (loss) per share	$	0.01	$	0.00		$	(0.05	)	$	(0.04	)
Diluted earnings (loss) per share	$	0.01	$	0.00		$	(0.05	)	$	(0.04	)
Basic weighted average common shares outstanding		7,463		7,280			7,450			7,272
Diluted weighted average common shares outstanding		8,122		8,323			7,450			7,272

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

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

GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)


	Six Months Ended June 30,
	2006			2005
				As Restated (1)
Cash Flows from Operating Activities:
Net loss	$	(379	)	$	(259	)
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		178			274
Gain on disposal of equipment		—			(2	)
Stock-based compensation		177			53
Reversal of provision for bad debt		(6	)		(17	)
Changes in assets and liabilities:
Accounts receivable		721			834
Prepaid expenses and other current assets		(199	)		(345	)
Accounts payable		(46	)		(5	)
Accrued expenses		231			(282	)
Deferred revenue		207			328
Other liabilities		49			—

Net cash provided by operating activities		933			579


Cash Flows from Investing Activities:
Purchases of property and equipment		(168	)		(157	)
Decrease in other assets		—			315

Net cash (used in) provided by investing activities		(168	)		158


Cash Flows From Financing Activities:
Principal payments on capital lease obligations		(53	)		(52	)
Proceeds from exercise of stock options		20			18

Net cash used in financing activities		(33	)		(34	)

Effect of Exchange Rate Changes on Cash		17			(170	)

Net Increase in Cash and Cash Equivalents		749			533
Cash and Cash Equivalents, Beginning of Period		3,176			2,927

Cash and Cash Equivalents, End of Period	$	3,925		$	3,460

Cash paid for income taxes	$	7		$	25
Cash paid for interest	$	10		$	12
Acquisition (divestiture) of equipment under capital lease obligations	$	27		$	(130	)

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

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

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Operations

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

2. Basis of Presentation

We have prepared the unaudited consolidated financial statements included in this report pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements prepared for the full year in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations; nevertheless, our management believes that the disclosures in this report are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments (of a normal and recurring nature as well as the restated adjustments described in Note 3) that are necessary to present fairly our consolidated financial position as of June 30, 2006 and December 31, 2005 and our results of operations and cash flows for the three- and six- month periods ended June 30, 2006 and 2005. These consolidated financial statements and notes thereto should be read in conjunction with the restated consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2006, filed with the SEC on June 6, 2007. The results of operations for interim periods are not necessarily indicative of the results of operations for the full year or any other interim period.

During the three-month period ended June 30, 2006, we were operating and overall profitable but for the six-month period ended June 30, 2006 we incurred operating and net losses, but achieved positive cash flow. During the year ended December 31, 2005, we also incurred operating and net losses, but achieved positive cash flow. This was in contrast to the year ended December 31, 2004 when we maintained operating and overall profitability. We believe that our cash and cash equivalent balance and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least the next 12 months. Our ability to restore growth and profitability in 2006 and beyond is dependent on market acceptance of our existing and next generation of G2 and G2-based products and related services and on renewal of maintenance contracts for customer support at near-current levels.

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

3. Restatement of Previously Issued Financial Statements

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

Review of Accounting for Software License and Service Agreement Transactions

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

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

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

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

•

non-standard maintenance terms

•

extended payment terms

•

license upgrades without associated maintenance

•

temporary access codes

•

return or upgrade rights with distributors and resellers

•

consulting services provided beyond those considered routine

•

delayed delivery

•

orders containing references to earlier transactions

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

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

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

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

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

•

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

•

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

•

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

•

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

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

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

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

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

Other Accounting Adjustments

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

Findings, Restatement and Remediation

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

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Cumulative Effect of Adjustments on Accumulated Deficit

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


	1999 and Prior			2000			2001			2002			2003			2004			2005			First Quarter of 2006
	As Restated (1) (in thousands)
Net (loss) income as originally reported	$	—		$	(12,816	)	$	(3,749	)	$	1,644		$	(1,783	)	$	894		$	(663	)	$	(575	)

Adjustments related to:
Revenue Recognition		(790	)		(1,335	)		1,331			(103	)		162			101			(579	)		99
Stock Compensation		(35	)		(120	)		(33	)		(14	)		(31	)		(15	)		6			—
Other Accounting Adjustments		—			—			—			—			204			(24	)		(24	)		3

Net adjustments		(825	)		(1,455	)		1,298			(117	)		335			62			(597	)		102

Net (loss) income as restated		(825	)		(14,271	)		(2,451	)		1,527			(1,448	)		956			(1,260	)		(473	)

Cumulative effect to Accumulated Deficit	$	825		$	2,280		$	982		$	1,099		$	764		$	702		$	1,299		$	1,197

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

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

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share and per share amounts)


	December 31, 2005
	As Reported			As Restated
ASSETS
Current Assets:
Cash and cash equivalents	$	3,176		$	3,176
Accounts receivable, net of allowance for doubtful accounts of $42 at June 31, 2006 and $48 at December 31, 2005		3,987			3,987
Prepaid and other current assets		336			345

Total current assets		7,499			7,508

Property and equipment, net		599			599
Deposits and other assets		153			334

Total Assets	$	8,251		$	8,441

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	495		$	495
Accrued expenses		1,533			1,541
Current portion of capital lease obligation		101			101
Deferred revenue		4,740			5,119

Total current liabilities		6,869			7,256

Capital lease and other long term liabilities, net of current portion		179			179
Long term deferred revenue		206			1,084

Total Liabilities		7,254			8,519

Commitments and contingencies
Stockholders’ Equity:
Preferred stock $.01 par value-authorized 2,000,000 shares issued and out standing—none
Common stock $.01 par value—authorized—20,000,000 shares issued—7,773,222 shares outstanding—7,429,541 shares , respectively		78			78
Capital in excess of par value		22,148			22,372
Treasury stock—332,369 shares in 2006 and 343,681 shares in 2005 at cost respectively		(1,282	)		(1,282	)
Accumulated deficit		(19,916	)		(21,215	)
Accumulated other comprehensive income		(31	)		(31	)

Total stockholders’ equity		997			(78	)

Total liabilities and stockholders’ equity	$	8,251		$	8,441

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)


	Three Months Ended June 30,				Six Months Ended June 30,
	2005		2005		2005		2005
	As Reported		As Restated		As Reported		As Restated
Revenues:
Product	$	1,744	$	1,785	$	4,038	$	3,605
Services		2,914		2,888		5,763		5,760

Total revenues		4,658		4,673		9,801		9,365

Cost of revenues:
Product		106		106		255		255
Services		1,234		1,234		2,432		2,432

Total cost of revenues		1,340		1,340		2,687		2,687

Gross profit		3,318		3,333		7,114		6,678

Operating expenses:
Sales and marketing		1,302		1,302		2,709		2,709
Research and development		981		981		2,018		2,018
General and administrative		1,020		1,022		2,160		2,164

Total operating expenses		3,303		3,305		6,887		6,891

Operating (loss) income		15		28		227		(213	)

Other expense, net		1		7		6		22

Income (loss) before provision for income taxes		14		21		221		(235	)

Provision for income taxes		8		8		24		24

Net income (loss)	$	6	$	13	$	197	$	(259	)

Basic earnings (loss) per share	$	0.00	$	0.00	$	0.03	$	(0.04	)
Diluted earnings (loss) per share	$	0.00	$	0.00	$	0.02	$	(0.04	)

Basic weighted average common shares outstanding		7,280		7,280		7,272		7,272
Diluted weighted average common shares outstanding		8,457		8,323		8,447		7,272

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)


	Six Months Ended June 30,
	2005			2005
	As Reported			As Restated
Cash Flows from Operating Activities:
Net (loss) income	$	197		$	(259	)
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		274			274
Loss on disposal of equipment		(2	)		(2	)
Reversal of provision for bad debt		—			(17	)
Stock-based compensation		48			53
Changes in assets and liabilities:
Accounts receivable		817			834
Prepaid expenses and other current assets		(389	)		(345	)
Accounts payable		(5	)		(5	)
Accrued expenses		(253	)		(282	)
Deposits and other assets		—			—
Deferred revenue		(108	)		328

Net cash provided by operating activities		579			579

Cash Flows from Investing Activities:
Purchases of property and equipment		(157	)		(157	)
Decrease in other assets		315			315

Net cash provided by investing activities		158			158

Cash Flows From Financing Activities:
Principal payments on capital lease obligations		(52	)		(52	)
Proceeds from exercise of stock options		18			18

Net cash used in financing activities		(34	)		(34	)

Effect of Exchange Rate Changes on Cash		(170	)		(170	)
Net Increase in Cash and Cash Equivalents		533			533
Cash and Cash Equivalents, Beginning of Period		2,927			2,927

Cash and Cash Equivalents, End of Period	$	3,460		$	3,460

Cash paid for income taxes	$	3		$	25

Cash paid for interest	$	4		$	12

Divesture of equipment under capital lease obligations	$	(130	)	$	(130	)

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. Comprehensive Income (Loss)

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


	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
				As Restated (1)						As Restated (1)
Net income (loss)	$	94		$	13		$	(379	)	$	(259	)
Other comprehensive (loss) income :
Foreign currency translation adjustment		(1	)		(115	)		17			(181	)

Comprehensive income (loss)	$	93		$	(102	)	$	(362	)	$	(440	)

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

5. Net Income (loss) Per Share

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

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Weighted average common shares outstanding		7,463			7,280			7,450			7,272
Additional dilutive common stock equivalents		659			1,177			—			—

Diluted weighted average shares		8,122			8,457			7,450			7,272

For the six-month periods ended June 30, 2006 and 2005, options to purchase 1,598,922 and 1,822,989 shares of common stock, respectively, were outstanding, but were not included in the computation of diluted earnings per share because the shares were anti-dilutive as we had a net loss for the periods.

6. Stock Based Compensation

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

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

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

We have elected the modified prospective transition method for adopting SFAS No. 123R. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. The unrecognized expense of awards not yet vested at the date of adoption are recognized in net income in the periods after the date of adoption using the same valuation method (i.e. Black-Scholes) and assumptions determined under the original provisions of SFAS No. 123,Accounting for Stock-Based Compensation, as disclosed in our previous filings. Accordingly, prior period financials have not been restated for this purpose. Under the provisions of SFAS 123(R), we recorded $73,000 and $167,000 of stock-based compensation on our consolidated condensed statements of operations for the three- and six- months ended June 30, 2006, including no compensation related to the issuance of shares of common stock to our board of directors members for the three-month period ended June 30, 2006 and $10,000 of compensation related to the issuance of 5,306 shares of common stock to our board of directors members for the six-month period ended June 30, 2006. The stock-based compensation for the three and six months ended June 30, 2006 is included in the following expense categories (in thousands):

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


	Three Months Ended June 30, 2006		Six Months Ended June 30, 2006
Cost of service and other	$	3	$	6
Selling and marketing		7		15
Research and development		4		10
General and administrative		59		136

	$	73	$	167

During the six months ended June 30, 2006, we also issued 6,006 shares of common stock with a fair value of $10,000 to members of management in lieu of cash payment for a portion of their bonus accrued in 2005. This amount was excluded from the table above.

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

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


	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
	As Restated (1)
Net (loss) attributable to common shareholders—
As reported	$	13		$	(259	)
Less: Stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		132			263
Add: Stock-based compensation expense included in reported net income		12			23

Pro forma net loss	$	(107	)	$	(499	)

Net income attributable to common shareholders per share—basic
As reported	$	0.00		$	(0.04	)
Pro forma		(0.01	)		(0.07	)

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

Our results for the three- and six- months ended June 30, 2005 included $10,000 of stock-based compensation related to the issuance of 2,438 shares of common stock, and $19,000 of stock-based compensation related to the issuance of 5,052 shares of common stock to the Company’s board of directors members, respectively. During the three and six months ended June 30, 2005 we recorded $2,000 and $4,000 of compensation expense in accordance with APB No. 25.

During the three- and six- months ended March 31, 2005 we also issued 5,978 and 7,624 shares of common stock with a fair market value of $23,000 and $29,000 to members of management in lieu of cash payment for a portion of their bonus accrued during 2004. This amount was excluded from the table above.

We utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted after the adoption of SFAS No. 123R. The weighted-average fair values of the options granted under the stock option plans were $2.09 and $1.68 for the three- and six- months ended June 30, 2006 as compared to $3.80 and $3.78 for the same periods in 2005, using the following assumptions:

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


	Six Months Ended June 30,
	2006	2005
Average risk free interest rates	5.00%	4.26%
Expected dividend yield	None	None
Expected life	7 Years	7 Years
Expected volatility	130%	139%

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

Based on our historical voluntary turnover rates, an annualized estimated forfeiture rate of 6% has been used in calculating the recorded expense. Under the true-up provisions of SFAS No. 123R, additional expense will be recorded if the actual forfeiture rate is lower than estimated, and a recovery of prior expense will be recorded if the actual forfeiture is higher than estimated.

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


	Number of Stock Options		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term in Years	Aggregate Intrinsic Value ($000’s)
Outstanding at December 31, 2005 – As Restated (1)	1,665,224		$	1.40
Granted	330,000			1.80
Exercised	(9,300	)		0.58
Forfeited	(213,634	)		1.93

Outstanding at March 31, 2006	1,772,290		$	1.42	7.19	$	1,922

Exercisable at March 31, 2006	1,336,920		$	1.38	6.50	$	1,614
Granted	6,500			2.25
Exercised	(20,834	)		0.72
Forfeited	(159,034	)		2.39

Outstanding at June 30, 2006	1,598,922		$	1.34	6.49	$	674

Exercisable at June 30, 2006	1,163,558		$	1.26	5.73	$	619

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

As of June 30, 2006 we had $494,000 of unrecognized compensation cost related to unvested awards, which we expect to recognize over a weighted-average period of 2 years.

The total intrinsic value of options exercised for the three-months ended June 30, 2006 and 2005 were $41,000 and $82,000, respectively. Total intrinsic value of options exercised for the six-months ended June 30, 2006 and 2005 were $53,000 and $82,000, respectively.

7. Segment Reporting

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

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
United States	53	%	51	%	50	%	50	%
Sweden	8	%	11	%	8	%	11	%
Asia	6	%	5	%	8	%	7	%
Rest of Europe	19	%	23	%	21	%	20	%
Rest of World	14	%	10	%	13	%	12	%

	100	%	100	%	100	%	100	%

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

Revenues from one customer represented 17% and 14% of total revenues for the three and six months ended June 30, 2006. Revenues from two customers represented 22% of total revenues for the three months ended June 30, 2005 and 17% from one customer for the six months ended June 30, 2005.

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


	June 31, 2006		December 31, 2005
			As Restated (1)
United States	$	581	$	527
Europe		55		72

Total	$	636	$	599

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

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements and information relating to us and our subsidiaries, which are based on management’s beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used in this Quarterly Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to our management or us, identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth in Item 1A of Part II under the caption “Risk Factors.” Should one or more of these risks or uncertainties materialize, or should an underlying assumption prove incorrect, actual results may vary materially from those described in this report as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or revise any forward-looking statements.

Restatement of previously issued financial statements

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

Business Overview

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

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

•

greater agility in responding to changing business conditions;

•

increased production capacities;

•

reduced consumption of energy, materials and resources;

•

avoidance of capital expenditures;

•

waste reduction;

•

higher levels of product and service quality; and

•

avoidance of costly operational disruptions and shutdowns.

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

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

Our current products are:


Product		Application

G2^©		Real-time, rule engine platform for optimizing operations and detecting, diagnosing and responding to problems in real time.

G2 NeurOn-Line™		Online, rule-driven neural-network models that predict, control and optimize complex non-linear processes.

G2 Optegrity^©		Abnormal condition management for process manufacturing plants.

G2 Integrity™		Expert fault management of voice and data networks.

G2 ReThink^®		Management of the business process life cycle through rule-driven simulation and online automation.

G2 e-SCOR		Simulation and analysis of supply-chain designs, policies and practices.

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

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

•

Sale of product licenses—mostly one-time payment for perpetual licenses.

•

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

•

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

•

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

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

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

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


	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
Product license sales	37	%	38	%	40	%	38	%
Consulting and educational services	23	%	24	%	20	%	24	%
Customer support services	40	%	38	%	40	%	38	%

Total	100	%	100	%	100	%	100	%

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

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

Critical Accounting Policies

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

For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2005. During the six-month period ended June 30, 2006 we adopted Statement of Financial Standard No. 123 (Revised 2004),Share-Based Payment, (SFAS No. 123R) which is fully explained in footnote 6 to the financial statements.

Results of Operations

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


	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
Revenues:
Product	37	%	38	%	40	%	38	%
Services	63	%	62	%	60	%	62	%

Total revenues	100	%	100	%	100	%	100	%

Cost of revenues:
Product	2	%	2	%	3	%	3	%
Services	28	%	27	%	25	%	26	%

Total cost of revenues	30	%	29	%	28	%	29	%

Gross profit	70	%	71	%	72	%	71	%

Operating expenses:
Sales and marketing	25	%	28	%	29	%	29	%
Research and development	16	%	21	%	20	%	21	%
General and administrative	27	%	22	%	28	%	23	%

Total operating expenses	68	%	71	%	77	%	73	%

Operating (loss) income	2	%	1	%	(5	)%	(2	)%
Other income (expense), net	—	%	1	%	—	%	—	%

(Loss) income before provision for income taxes	2	%	—	%	(5	)%	(3	)%
Provision for income taxes	—	%	—	%	—	%	—	%

Net (loss) income	2	%	—	%	(5	)%	(3	)%

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

Revenues

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


	Three Months Ended June 30,								Six Months Ended June 30,
	2006				2005				2006				2005
					As Restated (1)								As Restated (1)
U.S.	$	2,376	53	%	$	2,392	51	%	$	4,193	50	%	$	4,707	50	%
International		2,076	47	%		2,281	49	%		4,147	50	%		4,658	50	%

Total revenues	$	4,452			$	4,673			$	8,340			$	9,365

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

The decrease in overall revenue of $0.2 million, or 5%, between the three-months ended June 30, 2006 and the same period in 2005 was primarily due to a general decrease in license revenue and a decrease in consulting projects. The decrease in overall revenue of $1.0 million, or 11%, between the six-months ended June 30, 2006 and the same period in 2005 was primarily attributable to a decrease in government consulting projects, a decrease in license revenue and a decrease in maintenance support contracts.

U.S. revenue decreased between the three-month period ended June 30, 2006 and the same period in 2005, primarily as a result of a $0.1 decrease in license sales partially offset by an increase in consulting sales. U.S. revenue increased between the two periods as a percentage of sales as the U.S. portion of sales did not decrease to the same degree as overall sales. International revenue decreased between the two periods in revenue dollars primarily as a result of a decrease in European consulting projects.

U.S. revenue decreased for the six-month period ended June 30, 2006 as compared to the six month period ended June 30, 2005, as a result of a decrease in general license sales and consulting revenue from a U.S. government prime contractor during 2005 that was not repeated at the same level in 2006. International revenue decreased between the two periods as a result of decrease in international consulting projects.

We had one customer that accounted for 17% and 22% of revenue for the three-month periods ended June 30, 2006 and 2005 respectively. We had one customer that accounted 14% and 17% of revenue for the six-month period ended June 30, 2006 and 2005 respectively.

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


	Three Months Ended June				Six Months Ended June
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
Revenues:
Product	$	1,628	$	1,785	$	3,320	$	3,605
Services		2,824		2,888		5,020		5,760

Total Revenues	$	4,452	$	4,673	$	8,340	$	9,365

(1)	See Note 3, to the Consolidated Financial Statements included in Part I, Item 1 in 2005.

Services revenues for the three months ended June 30, 2006 decreased $0.1 million, or 2%, as compared to the same period in 2005. This decrease was mainly attributable to a decrease in consulting projects. Services revenues for the six months ended June 30, 2006 decreased $0.7 million, or 13%, as compared to the same period in 2005. This decrease was mainly attributable to the receipt of a large government order in 2005 that we did not receive in 2006, a decrease in general European consulting projects, and a reduction in software support contracts.

Cost of Revenues

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


	Three Months Ended June				Six Months Ended June
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
Cost of Revenues:
Product	$	96	$	106	$	227	$	255
Services		1,240		1,234		2,098		2,432

Total Cost of Revenues	$	1,336	$	1,340	$	2,325	$	2,687

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

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

Service costs also remained relatively the same, for the three months ended June 30, 2006 as compared to the same period in 2005. This was primarily attributable to a $0.1 million increase in labor costs associated with new employees, $0.1 million of costs associated with the projected loss on a fixed price contract in overrun, partially offset by a $0.1 decrease in outside contractors, $0.04 million decrease in travel, and a $0.04 million decrease in bonus due to lower consulting sales. Service costs decreased $0.3 million, or 14%, for the six months ended June 30, 2006 as compared to the same period in 2005. This decrease was primarily attributable to a $0.3 million decrease in outside subcontractor costs, $0.2 million deferral of cost to work in progress, partially offset by a $0.2 million increase in labor associated with new employees and $0.2 million of costs associated with the projected loss on a fixed price contract in overrun.

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


	Three Months Ended June				Six Months Ended June
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
Gross margins:
Product	94	%	94	%	93	%	93	%
Services	56	%	57	%	58	%	58	%

Total Gross Margin	70	%	71	%	72	%	71	%

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

Our gross margin on product remained relatively the same at 94% and 93% during the three- and six- month periods ended June 30, 2006 as compared to the same periods in 2005. Our product expenses are relatively low and consistent as they generally consist of fixed labor and facility costs, therefore, the gross margin remains consistent unless there is a significant change in license revenue.

Our gross margin on service remained relatively the same for the three- month periods ending June 30, 2006 and 2005 at 56% to 57% and for the six-month periods ended June 30, 2006 and 2005 at 58%. This is a result of maintaining consistent utilization rates for internal staff and using contractors to manage increases in revenue.

Operating Expenses


	Three Months Ended June				Six Months Ended June
	2006		2005		2006		2005
			As Restated (1)				As Restated (1)
Operating expense:
Sales and marketing	$	1,113	$	1,302	$	2,417	$	2,709
Research and development		739		981		1,700		2,018
General and administrative		1,196		1,022		2,293		2,164

Total operating expense	$	3,048	$	3,305	$	6,410	$	6,891

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

Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising, and promotional materials. These expenses for the three-month period ended June 30, 2006 were $1.1 million, a decrease of $0.2 million, or 15%, as compared to the same period in 2005. The decrease was primarily attributable to a $0.1 decrease in commissions based on lower paying programs in 2006, a $0.1 decrease in marketing programs based on cost reduction programs, a $0.03 reduction in facility expense as a result of the consolidation of our headquarter office. These expenses for the six-month period ended June 30, 2006 were $2.4 million, a decrease of $0.3 million, or 11%, as compared to the same period in 2005. The decrease was primarily the result of a $0.2 million reduction in commission based on new, lower paying commission plans, and a $0.1 million decrease in facility cost as a result of consolidation of our headquarter office.

Research and Development. Research and development expenses consist primarily of costs of personnel, equipment and facilities. Expenditures include research and support of the existing G2 product line and, in the three- and six- months ended June 30, 2005 included the development of the software reasoning platform, TrueManage that was discontinued in 2006. Total research and development expenses for the three months ended June 30, 2006 were $0.7 million, a decrease of $0.2 million or 25% from the comparable period in 2005. This decrease is primarily due to a $0.2 million decrease in personnel and contractors for the TrueManage program, and a $0.1 million decrease in facility cost due the reduction of personnel and the consolidation of our headquarters. Total research and development expenses for the six months ended June 30, 2006 were $1.7 million, a decrease of $0.3 million or 16% from the comparable period in 2005. This decrease is primarily the result of $0.2 million decrease in personnel for the TrueManage program, and a $0.1 million decrease in facility cost due to the reduction of personnel and the consolidation of our headquarters.

General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations and general management, as well as legal and accounting expenses. These expenses for the three months ended June 30, 2006 increased $0.2 million or 17% as compared to the same period in 2005. This increase was a result of, a $0.3 million increase in legal expenses associated with corporate planning, offset by a decrease a $0.1 million decrease in facility costs attributable to the consolidation of our headquarters. The expense for the six months ended June 30, 2006 increased $0.1 million or 6% from the comparable period in 2005. This was primarily the result of a $0.3 million increase in legal expense associated with corporate planning and the restatement, a $0.1 million increase in stock based compensation as a result of the adoption of SFAS 123R, offset by a $0.1 million decrease in facility costs attributable to the consolidation of our headquarters, a one time $0.1 million termination settlement in 2005, and a $0.05 million decrease in contractor support.

Other Income, Expense

Other income, net for the three- and six- months ended June 30, 2006 was $33,000 and $25,000, compared to other expense, net of $7,000 and $22,000 for the same periods in 2005. The decrease is primarily due to foreign exchange rate fluctuations.

Income Taxes

Our provision for income taxes results from anticipated income tax credits in the U.S. based on operating loss carry forwards offset by tax liabilities in foreign jurisdictions where our wholly owned subsidiaries have taxable income but may not have operating loss carry forwards to reduce tax obligations. Provision for income taxes for the three- and six- months ended June 30, 2006 was $7,000 and $9,000 compared to $8,000 and $24,000 for the same periods in 2005. As the company has an operating loss, the provision is minimal.

LIQUIDITY AND CAPITAL RESOURCES

Our June 30, 2006 cash and cash equivalents were $3.9 million, an increase of $0.7 million from December 31, 2005.

For the six months ended June 30, 2006, we had $1.0 million provided by operating activities offset by $0.2 million used in investing activities and $6,000 used in financing activities.

We reported $1.0 million and $0.6 million of cash flow from operations for the six months ended June 30, 2006 and 2005, respectively. The difference was primarily a result of $0.1 million of greater loss offset by $0.2 million decrease in prepaid expenses and other assets as the company recognized previously paid expenses, $0.1 million decrease in deferred revenue as previously paid contracts became recognized revenue, $0.1 million from an increase in accounts receivable due the company, and lower operating cash outflows of $0.5 million as accrued expenses increased.

Cash flows used in investing activities were $0.2 million for the six month period ended June 30, 2006 and was primarily used for purchases of property and equipment. Cash provided by investing activities was $0.2 million for the six month period ended June 30, 2005 and was primarily due to a $0.3 million return of a security deposit offset by $0.1 million in purchases of property and equipment.

Cash flows used in financing activities were $33,000 and $34,000 for the six-month periods ended June 30, 2006 and 2005 and were primarily used for principal payments on capital lease obligations.

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

Commitments and Contingencies

Leases

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


	(in thousands)
For the period ended December 31,	Operating Leases		Capital Leases
2006	$	308		60
2007		562		110
2008		427		22
2009		392		8
2010		392		1
Thereafter		110		—

Total minimum lease payments	$	2,191	$	201
Less: Amount representing interest				17

Present value of minimum lease payments				184
Less: Current portion				108

Long-term portion of capital lease obligation			$	76

Litigation

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

Stock Repurchase Program

In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of June 30, 2006, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2006, 2005 or 2004. During the three months ended June 30, 2006 and 2005, respectively, we reissued 0 and 8,416 shares of common stock to employees and non-employee directors. As of June 30, 2006, 332,369 shares remained in treasury at a cost of $1,239,736.

Related party transaction

On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving three employees who continue to work for us. In March 2005, July 2005, June 2006 and April 2007 we extended the agreement for additional increments. The contract expired on February 13, 2007. On February 15, 2007 we signed a new one-year Original Equipment Manufacturer agreement which will expire on February 14, 2008. Both agreements call for the payment of royalties, based on a fixed and determinable percentage of the product sales

price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. In April 2007 we terminated one of the employees involved with Integration Objects and determined that the other two employees were no longer associated with Integration Objects. During the three- and six- month periods ended June 30, 2006, we paid Integration Objects a total of $0 and $28,168 respectively. At June 30, 2006 we had unpaid royalties of $21,424 due to Integration Objects, Inc.

On April 21, 2005 we entered into a six month consulting agreement with Cianciotta Holdings, Inc., an entity wholly-owned by Frank Cianciotta, who was then a member of our board of directors. Pursuant to the agreement, Cianciotta Holdings, Inc. provided business development and sales consulting services to us, which services were performed by Mr. Cianciotta. The agreement called for payments of $6,500 per month to assist in strategic business development opportunities. In September 2005, we entered into a consulting agreement with Market Partners, Inc., a provider of consulting and technology solutions. Pursuant to the agreement, Market Partners, Inc. provided business development and sales consulting services to us, which services were provided by Mr. Cianciotta who was a subcontractor for Market Partners, Inc. We agreed to pay Market Partners, Inc. $10,000 per month for consulting services and an additional $3,333 per month for the first six months of the agreement as a performance bonus. After the first six months, the monthly performance bonus payment under the agreement was to be an amount equal to 5% of our gross revenue for web hosted business or software delivered on a monthly service fee basis. We terminated the agreement with Market Partners, Inc. effective March 1, 2006. Mr. Cianciotta resigned from our board of directors effective October 27, 2005. We paid Mr. Cianciotta or Market Partners, Inc. a total of $44,686 for the three- and six- months ending June 30, 2006 pursuant to these consulting agreements. At June 30, 2006 we had no unpaid consulting fees owed to Mr. Cianciotta or Market Partners, Inc.

New Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No.48,Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No.109(FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December15, 2006, with early adoption permitted. We will adopt FIN 48 on January 1, 2007. We are currently evaluating the impact that the adoption of FIN 48 will have on our consolidated financial statements.

ITEM 3.

Quantitative and Qualitative Disclosures About Market Risk

Investment Portfolio

We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand deposit accounts, we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At June 30, 2006, substantially all of our funds were in demand deposit accounts.

Impact of Foreign Currency Rate Changes

Our contracts with customers are generally denominated in U.S. dollars or Euros. We transact business in various countries and thus have exposure to adverse movements in foreign currency exchange rates. This exposure is primarily related to intercompany receivable and payable balances that are recorded on the balance sheet in currencies other than the functional currency. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the currency translation adjustment of the equity section of the balance sheet. In addition, we have certain cash balances held in currencies other than our functional currency or the functional currency of our subsidiaries. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the appropriate statements of operations.

ITEM 4.

Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure

controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2006, as a result of the material weaknesses in our internal controls over financial reporting described below, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective.

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

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

The following material weaknesses collectively resulted in us prematurely recognizing revenue, thereby causing revenue to be overstated in an earlier period and understated in a later period, deferred revenue to be understated in any period, costs and expenses to vary in any particular period and our net loss to be understated in an earlier period and overstated in a later period. As a consequence, we have restated our historical financial statements, as described elsewhere in this Quarterly Report on Form 10-Q, resulting in an increase in revenue in the quarter ended June 30, 2005 of $15,000 and an increase in net income in the quarter ended June 30, 2005 of $7,000.

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

•

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

•

insufficient flow of documentation and information between operations and finance personnel;

•

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

•

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

•

insufficient tracking of the issuance and return of license key codes;

•

insufficient tracking of inventory maintained by resellers; and

•

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

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

•

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

•

developing and implementing internal controls and compliance training programs for sales, operation and finance;

•

implementing personnel changes;

•

establishing clear and concise corporate polices, practices and controls; and

•

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

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

•

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

•

formalization of ongoing reporting of contact status and issues to senior management, including the chief financial officer.

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

PART II. OTHER INFORMATION

ITEM 1.

Legal Proceedings

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

ITEM 1A.

Risk Factors

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

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

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

We conducted a review and investigation of several accounting issues with the assistance of outside legal counsel and outside accounting specialists. The review and investigation included a review of our revenue recognition accounting for certain software license and service agreement transactions, stock option practices and related stock-based compensation expense

and other accounting adjustments, including foreign tax filing errors and accounting timing adjustments. These review and investigations, and related activities, have required us to incur substantial expenses for legal, accounting, tax and other professional services, and have diverted management’s attention from our business.

As a result of the review and investigation of our accounting practices, we restated previously released financial statements for 2000 through the first quarter of 2006. We also recorded cumulative effect adjustments for fiscal years 2000 through 2003, the effects of which are indicated as adjustments to our financial statements as of December 31, 2003. For more information on these matters, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 3 to our Consolidated Financial Statements.

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

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

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

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

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

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

•

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

•

insufficient flow of documentation and information between operations and finance personnel;

•

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

•

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

•

insufficient tracking of the issuance and return of license key codes;

•

insufficient tracking of inventory maintained by resellers; and

•

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

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

We have implemented and continue to implement a number of remedial measures designed to address the material weaknesses identified as of June 30, 2006. If these remedial initiatives are insufficient to address the identified material weaknesses, or if additional material weaknesses or significant deficiencies in our internal control are discovered in the future, we may fail to meet our future reporting obligations on a timely basis, our financial statements may contain material misstatements, our operating results may be harmed, we may fail to meet our future reporting obligations on a timely basis, we may be subject to litigation. Any failure to address the identified material weaknesses or any additional material weaknesses or significant deficiencies in our internal control could also adversely affect the results of future management evaluations regarding the effectiveness of our “internal control over financial reporting” that are required under Section 404 of the Sarbanes-Oxley Act of 2002. Internal control deficiencies could also cause investors to lose confidence in our reported financial information.

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

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

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

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

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

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

We were profitable for the three months ended June 30, 2006 and incurred operating losses for three of the five years ended December 31, 2005. We were profitable for the second quarter of 2006 but operating losses for the first quarter of 2006 that caused us to incur an operating loss for the first six months of 2006. As of June 30, 2006, our accumulated deficit was $21.6 million. Our ability to achieve and maintain profitability is dependent on continued revenues from new and existing customers and expense control. There can be no assurance that we will return to profitability and even if we achieve profitability, we cannot assure that we can sustain profitability on a quarterly or annual basis.

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

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

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

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

We rely heavily on indirect distribution channels and strategic partner relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.

We sell our products in part through value-added resellers, systems integrators, original equipment manufacturers and distributors, which are not under our control. Sales of our products by such channel partners represented 58%, 51% and 58% of our product revenues in years ended December 31, 2005, 2004 and 2003, respectively. Sales of our products by channel partners represented 73% and 72% of our total sales for the three- and six- months ended June 30, 2006. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing successful G2-based applications could have a material adverse effect on our business, results of operations, cash flows and financial position. There can be no assurance that we will be able to attract or retain additional qualified third-party resellers, or that third-party resellers will be able to effectively sell and implement our products. In addition, we rely on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service and support could adversely affect our business, results of operations, cash flows, and financial position.

We depend heavily on our sales and marketing force.

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

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

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

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

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

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

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

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

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

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

Our international revenues represented 47%, 49%, and 56% of our total revenues for years ended December 31, 2005, 2004, and 2003, respectively. Our international revenues represented 47% and 50% of our total revenues for the three- and six- months ended June 30, 2006. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. Our international operations require significant management attention and financial resources.

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

•

changes in foreign currency exchange rates;

•

unexpected changes in politics and regulatory requirements;

•

tariffs and other trade barriers;

•

costs of localizing products for foreign countries;

•

lack of acceptance of products in foreign countries;

•

longer accounts receivable payment cycles;

•

difficulties in building and managing international operations;

•

tax issues, including restrictions on repatriating earnings;

•

weaker intellectual property protection in other countries;

•

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

•

the burden of complying with a wide variety of foreign laws.

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

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

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

In addition, we rely on many of our distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial results are also linked to the continued successful product development by our partners and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a result of competitive products, price competition, the lack of success of our partners, technological change, the shift in customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of operations, cash flows, or financial position.

Our software is complex and may contain undetected errors. Such errors could cause costly delays in product introduction or require costly software design modifications.

Complex software products such as those that we offer may contain unintended errors or failures commonly referred to as “bugs.” There can be no assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have not experienced material adverse effects resulting from any such errors or defects to date, there can be no assurance that errors or defects will not be discovered in the future that could cause delays in product introduction and shipments or require design modifications that could adversely affect our business, results of operations, cash flows, or financial position.

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

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

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

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

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

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

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

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

•

actual or anticipated fluctuations in our operating results;

•

developments or disputes concerning proprietary rights;

•

the loss of key management or technical personnel;

•

technological innovations or new products;

•

governmental regulatory action;

•

fluctuations in currency exchange rates;

•

general conditions in the software industry;

•

broad market fluctuations; and

•

economic conditions in the United States or abroad.

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

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

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

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

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

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

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

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

Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or if third parties successfully assert infringement claims against us.

Our success is heavily dependent upon our proprietary technology. We rely upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and technology. We enter into confidentiality and/or license agreements with our employees, contractors, third-party resellers, and end users and limit access to and distribution of our software, documentation, and other proprietary information. In addition, we have placed technical inhibitors in our software that prevent such software from running on unauthorized computers. However, effective patent, copyright, and trade secret protection may not be available in every country in which our products are distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be adequate to prevent misappropriation of our technology by third parties, or that third parties will not be able to develop similar technology independently. In addition, there can be no assurance that third parties will not assert infringement claims in the future or that such claims will not be successful.

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

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

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of June 30, 2006, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2006, 2005 or 2004. The following table provides information about purchases by the company during the quarter ended June 30, 2006 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:

GENSYM PURCHASES OF EQUITY SECURITIES


Period	Total Number of Shares Purchased during Period (1)	Average Price Paid per Share		Total Number of Shares Purchased since Adoption of Program as Part of Publicly Announced Plans or Programs (2)	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs (3)
04/01/06-04/30/06	0	$	—	501,300	148,700
05/01/06-05/31/06	0		—	501,300	148,700
06/01/06-06/30/06	0		—	501,300	148,700

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

(2)

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

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

ITEM 6.

Exhibits

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


Exhibit Number		Description
31.1		Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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


		GENSYM CORPORATION
		(Registrant)

Dated: June 6, 2007		/s/ STEPHEN D. ALLISON
		Stephen D. Allison
		Chief Financial Officer (Principal Financial and Accounting Officer)

EXHIBIT INDEX


Exhibit Number		Description
31.1		Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	H.S. freshman Good

Gensym (GNSM) Inactive 10-Q2006 Q2 Quarterly report

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