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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the transition period from __________________________________ to __________________________________

Commission File Number

INTERNET SECURITY SYSTEMS, INC.

6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328

Registrant’s telephone number, including area code              (404) 236-2600    

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

     Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

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INTERNET SECURITY SYSTEMS, INC.

1.   Basis of presentation and significant accounting policies

     The consolidated financial statements of Internet Security Systems, Inc. (“ISS”) as of June 30, 2002 and for the three and six months ended June 30, 2002 and 2001 are unaudited and, in the opinion of management, contain all adjustments, consisting of normal recurring items necessary for the fair presentation of the financial position and results of operations for the interim periods. The consolidated financial statements include the accounts of Internet Security Systems, Inc. and its majority-owned subsidiaries. The consolidated balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all the footnotes required by accounting principles generally accepted in the United States for complete financial statements.

     These consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2001. The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results to be expected for the entire year. All significant intercompany accounts and transactions have been eliminated. Certain previously reported amounts have been reclassified to conform to the current presentation format.

     The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

2.   Other income and expense

     Other income reported in the quarter ended June 30, 2002 consists of a $1.9 million gain on the sale of an investment in an ISS distributor in Japan. The shares of the publicly traded company were acquired when the distributor was privately held and were subsequently sold on the open market. The gain is substantially offset by expenses included in the general and administrative category resulting from the consolidation of Tokyo-based operations from several different locations to a new centralized headquarters in Tokyo. Costs associated with this move included lease termination costs, including remaining rent payments, write-off of leasehold improvements and moving costs.

     Included in pretax income in the six months ended June 30, 2001, is a non-recurring other income item of $1.6 million generated from the sale of approximately 2% of the outstanding shares of our Asia-Pacific subsidiary in March 2001. As part of the planning for an IPO in Japan of a minority interest in our Asia-Pacific subsidiary that was completed in September 2001, options were granted in the subsidiary as a means of key employee retention and approximately 2% of the outstanding shares were sold to employees and key partners. The price was established based on a valuation of the company by an independent appraisal firm. The gain represents the difference between proceeds received and the underlying basis in the stock.

     In the six months ended June 30, 2001, the Company recorded a first quarter $1.1 million write-off of the remaining lease obligation on our previous Atlanta office space. This non-recurring expense originated in the quarter as available subleased space in the area grew substantially as the result of layoffs, closures and consolidations, diminishing the prospects of subleasing our old space.

3. Goodwill and intangible assets

      The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002. As a result, goodwill is no longer amortized, but is instead tested for impairment annually or sooner if circumstances indicate that it may no longer be recoverable. Upon adoption, the Company completed the transitional goodwill impairment assessment required by SFAS No. 142 and concluded that goodwill was not impaired at January 1, 2002.

      Goodwill and intangible assets are comprised of the following (in thousands):