Fortuna Silver Mines
Annual Report 2009

Plain-text annual report

BUILDING THE FOUNDATIONS OF A LEADING SILVER MINER T S X : F V I / L i m a S t o c k E x c h a n g e : F V I FORTUNA SILVER MINES INC. 2009 ANNUAL REPORT >> Since opening the Caylloma silver-lead- zinc-copper mine in Peru less than four years ago, Fortuna Silver Mines has become one of Latin America’s fastest- growing silver producers. Our second and largest asset, the San Jose silver-gold mine in Mexico, will triple the company’s silver-equivalent output when it opens in the third quarter of 2011. We remain focused on our primary goal of building the foundations of a leading silver miner in Latin America, a region where management holds particular expertise and experience and where we are pursuing additional accretive mining opportunities. 2 0 / 1 0 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Cover Photo: San Jose Project main access decline Photo (this page): Caylloma Mine- Animas Vein, level 12 All figures expressed in US dollars unless otherwise stated. pg.03 pg.04 pg.07 pg.10 Vision & Strategy Operating Highlights President’s Letter Chairman’s Letter pg.11 Social Commitment pg.13 Core Assets pg.24 Financial Reports MEXICO San Jose Project Ag, Au : Construction PERU Caylloma Mine Ag, Pb, Zn, Cu : Production Forward-Looking Statements Certain statements in this report constitute forward-looking statements and as such are based on an assumed set of economic conditions and courses of action. These include estimates of future production levels, expectations regarding mine production costs, expected trends in mineral prices and statements that describe Fortuna’s future plans, objectives or goals. There is a significant risk that actual results will vary, perhaps materially, from results projected depending on such factors as changes in general economic conditions and financial markets, changes in prices for silver and other metals, technological and operational hazards in Fortuna’s mining and mine development activities, risks inherent in mineral exploration, uncertain- ties inherent in the calculation of mineral reserves, mineral resources, and metal recoveries, the timing and availability of financing, governmental and other approvals, political unrest or instability in countries where Fortuna is active, including labour relations and other risk factors. HIGHLIGHTS: Caylloma Mine produced 1,682,546 ounces of silver (**), an increase of 109% over 2008 (805,057 ounces *) Production of zinc (28.4M pounds) and lead (25.1M pounds) increased by 22% and 52% respectively over 2008 High-grade silver- gold mineralization discovered in upper portion of Animas Vein at the Caylloma Mine; development underway for incorporation into mine plan by mid-2010 Copper circuit completed at Caylloma with commercial production of copper concentrates commencing in December 2009 Vision & Strategy: We are committed to building Fortuna into a leading silver mining company centered on developing mineral resources in Latin America. We will operate with a commitment to profitability, sustainable growth, high standards and the well-being of our workers, neighboring communities and the environment. 01 02 03 04 05 06 01 SIMON RIDGWAY, Chairman of the Board / 02 JORGE A. GANOZA DURANT, President, CEO and Director 03 THOMAS I. VEHRS, Vice President, Exploration / 04 JORGE R. GANOZA AICARDI, Vice President, Operations 05 MANUEL RUIZ-CONEJO CARLOS, Vice President, Project Development 06 LUIS DARIO GANOZA DURANT, Chief Financial Officer 4 0 / 3 0 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All permits for the construction and operation of a 1,500 tonnes per day (tpd) mine at San Jose received in Q4 2009 Pre-feasibility study completed at San Jose mine, construction decision announced Q2 2010 Commitment letter signed for a US$20M senior secured debt facility with The Bank of Nova Scotia Cash position of US$70 million + bank debt facility leaves Fortuna well funded for San Jose construction (estimated pre-operational capital expenditure of US$55.7 M), conduct exploration activities and seize accretive business opportunities within Latin America Fortuna´s shares listed on the Toronto Stock Exchange as of January 18, 2010 (*) Silver production contained in lead concentrate (**) Silver production contained in lead and copper concentrates OUR GROWTH 1. Focusing on Peru and Mexico, the world’s two largest silver producing STRATEGY INCLUDES: countries, where we can harness management’s extensive skills and experience in all facets of Latin American exploration and mining 2. Using knowledge and skills gained through development, mechanization and optimization of the Caylloma mine to more efficiently build the San Jose mine 3. Growing organically through brown-fields exploration and through acquisitions Expressed in US dollars 2009 2008 FINANCIAL HIGHLIGHTS (000’s) Sales Operating Income (loss) Net Income (loss) Earnings (loss) per share, basic and diluted Net cash provided by operating activities Cash end of the year $ 51,428 14,383 623 0.01 13,686 30,763 $ 24,867 (5,593) (910) (0.01) 8,356 29,454 RESULTS OF OPERATIONS Caylloma Mine, Peru Tonnes milled Average tonnes milled per day (tpd) Production (metal contained) Silver (oz) (*), (**) Lead (lbs) Zinc (lbs) Copper (lbs) (***) Unit cash cost and Net smelter return Unit cash cost (US$/oz Ag) Unit cash cost (US$/tonne) Unit NSR (US$/tonne) Average Selling Price Silver (US$/oz) Lead (US$ /lb) Zinc (US$/lb) Copper (US$/lb) 2009 2008 395,560 1,121 331,381 936 1,682,546 25,137,107 28,441,836 88,185 805,057 16,501,600 23,283,019 na (4.93) 46.00 124.00 14.65 0.78 0.75 3.17 (3.78) 46.41 87.00 15.02 0.95 0.85 na (*) 2009 Ag production contained in Pb and Cu concentrates (**) 2008 Ag production contained in Pb (***) 2009 Cu production for the month of December SILVER PRODUCTION 1 3 2 1. Caylloma Mine 2. Caylloma Mine: Crushing and stockpile 3. Caylloma Mine: Camp located at 4,500 m.a.s.l. Caylloma Mine (Ag) + San Jose Mine (Ag Eq) Caylloma* San Jose** (2009 – 2018e) M oz 8 7 6 5 4 3 2 1 0 2009 2010e 2011e 2012e 2013e 2014e 2015e 2016e 2017e 2018e e - estimate / * Ag / ** Ag, Au 6 0 / 5 0 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F TO OUR SHAREHOLDERS STRONG LONG-TERM In October of current mining rate. Total silver production POTENTIAL 2009, Fortuna for 2009 was 1.7 million ounces, which ac- celebrated its counted for 44% of revenue. Due to the con- third year anniversary as a producing mining tribution of lead, zinc and copper, we achieved company. During this time we invested over a cash cost per silver ounce, net of by-product US$70 million to build and expand the Cayl- credits, of negative US$4.93 per ounce. This loma Mine and advance our San Jose project figure ranks Fortuna among the lowest cost to the construction phase. Today, with the emerging silver producers. The financial San Jose Mine under construction, we are on benefits of our solid production expansions a direct path to increase our annual output and operating results were reflected in the to 7 million ounces of silver equivalent. We improved earnings and cash flow in the final stand in a solid financial position to execute quarter of 2009 and first quarter of 2010. the construction of San Jose and have been able to strengthen our Company by attract- Our objective at Caylloma over the next 24 ing and retaining talented employees. As months is to focus on improving operational we embark on this new phase of expansion, efficiencies before planning further capacity we look forward with enthusiasm to the new expansion. Our operations team is confident challenges that lie ahead. We are building the we can derive moderate growth from these foundations for a new leading silver miner in efficiency gains. Perhaps most exciting is the Latin America. recent exploration success reported on the up- per levels of the Animas vein. This new discov- OPERATING PERFORMANCE AT ery will advance Caylloma’s silver production CAYLLOMA—SUSTAINED PRODUCTION to the 2 million ounce per year benchmark. AND LOW COSTS Through sound execution of our vision and SAN JOSE, MEXICO—OUR SECOND investment plans for Caylloma, we have built MINE IN THE MAKING a very profitable operation. Mine throughput In late 2009 we concluded the permitting has now consolidated at 35,000 tonnes per process for construction and operation of a month or 1,200 tpd. Production is supported 1,500 tpd underground mine and processing by over 3 million tonnes of reserves, enough facility at our San Jose project in Mexico. In to ensure a mine life of over eight years at our April of 2010, we released the results of a 8 0 / 7 0 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F positive pre-feasibility study and subsequently ery, especially as we see how a historic mining our Board of Directors approved the start of district, with a production history spanning construction. Within the next 16 months, we almost 500 years, can still surprise us with a plan to deliver production at San Jose at an near surface, high-grade discovery. initial rate of 750 tpd and 2 million ounces of silver equivalent per year with subsequent ex- For 2010 we are expanding our exploration pansions to reach the design capacity of 1,500 programs and budgets. On the brown-fields tpd and 5 million ounces of silver equivalent area we hold approximately 68,000 hectares per year. Based on current reserves, the mine of exploration ground around our mines in life stands at nine years. By the time of this Peru and Mexico where we are expanding our writing, detail engineering was advanced and target generation and evaluation activities. In construction activities on the water project Peru, exploration drilling is currently being and tailings had begun. carried out and is also programmed at a num- ber of targets within the Caylloma District. In San Jose has several areas of opportunity we Mexico, we are evaluating exploration targets will work to capitalize on once the mine is in the Taviche district and are planning the in operation. The primary opportunity is to evaluation and follow-up of gold-in-soils and convert Inferred Resources to Measured and gold-in-stream sediment anomalies outlined Indicated Resources, and subsequently to by generative exploration activities in 2008. At Mineable Reserves, as we advance with the the San Jose property, drilling is planned for development of the upper levels of the mine. the southern extension of the Bonanza vein The potential gains of reserves from the system, where previous drilling intersected conversion of Inferred resources will allow for significant silver and gold mineralization inter- a faster and lower cost expansion to the design sections that merited follow up. capacity. Our new project generation team evaluated COMMITMENT TO EXPLORATION numerous opportunities in Peru, Mexico, Our exploration work in 2009 returned a new Argentina, Chile and Ecuador during 2009. high-grade silver and gold discovery in the up- For 2010, we are prioritizing project genera- per levels of the Animas Vein at the Caylloma tion work in Peru and Mexico where we can mine. This has emerged as an exciting discov- maximize the benefit of existing corporate in- TO OUR SHAREHOLDERS 1 1. Caylloma Mine: Bateas Vein end of shift frastructure. We look forward to reporting on of high safety standards. Our environmental the success of our project generation efforts. management programs in Peru and Mexico are designed to achieve zero effluent discharg- BUILDING THE FOUNDATIONS OF es into the environment. At San Jose, we A LEADING SILVER MINER are using an innovative and environmentally Fortuna begins 2010 with a strong balance friendly approach to source industrial water to sheet that includes US$70 million in cash. the project by using treated waste water from We have a solid production base of 2 million a neighboring community. And finally, we ounces of silver per year and a growth profile devote significant resources to ensure Fortuna that will take the Company to 7 million ounc- operates as a responsible neighbor. We work es of annual silver equivalent production as to be a strategic partner of our host communi- San Jose is commissioned and achieves design ties by assisting them in achieving their plans capacity. And we will accomplish this while and objectives for improved quality of life. maintaining one of the lowest production cost structures in the silver producer sector. I cannot finish without acknowledging and Key to achieving our plans and objectives is port of all of the Fortuna directors, officers, our commitment to operational and financial employees, contractors and collaborators who results, the health and safety of our workers, make Fortuna a great Company. thanking the resolute commitment and sup- to protecting the environment and to being a responsible neighbor within our host com- munities. We have a record of zero fatalities at our operations and we continue to invest in Jorge A. Ganoza Durant process imporovements and the maintenance President, CEO and Director 0 1 / 9 0 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F TO OUR SHAREHOLDERS BECOMING A LEADING Following three San Jose’s fast-track development represents a SILVER MINER years of steady remarkable achievement for any mining com- growth at the pany, junior or senior. As the mine comes on Caylloma Mine, your company has begun a stream in 2011, Fortuna will begin to double new and important chapter. As production at its silver equivalent output. At that point, we Caylloma stabilizes, and as we look forward will become a very different company from to a long and profitable mine life there, we what we are now—larger, significantly more are taking the next steps towards our goal of profitable and on the radar of much larger becoming a leading silver mining company. investors. This is a crucial phase for Fortuna. While we Looking beyond San Jose—which is a key part have certainly proven ourselves capable of of our goal of becoming a leading silver pro- finding, developing and operating a successful ducer—we plan to make another acquisition mine, the market waits to see if we can do the that will continue our rapid growth in silver same with a much larger asset at San Jose. We resources and production. Nearly all market of course believe we can. factors point to long-term high prices for silver as well as other metals. With what we’ve We have learned a great deal from our experi- learned at Caylloma, and what we will surely ence at Caylloma. And there is no substitute learn from building and operating San Jose, for experience. So with the groundwork com- we believe we can locate, explore, develop and pleted—not the least of which was developing operate other projects profitably. In short, an economic high-grade silver-gold resource— we’re confident in our ability to deliver long- we move into the construction phase at San term growth and shareholder value. Jose with confidence. Funding is in place, permits, power and water have been secured, My heartfelt thanks go to everyone in the For- and planning is complete. tuna family including directors, management, staff and consultants. We have accomplished It’s important to remember that we are just so much in such a short period of time, which beginning to understand San Jose’s long-term has been possible only because of the team- potential. We took our first samples there in work and dedication everyone has shown day 2006. A mere four years later, we are prepar- after day in Peru, Mexico and Canada. I look ing to mine a deposit that to date contains forward to new achievements in 2010 and the more than 37 million ounces of silver equiva- very exciting years beyond. lent in the Indicated category and over 30 million ounces Inferred. Unexplored targets across the property’s 68,000 hectares, how- ever, could add considerably to this total and Simon Ridgway add many years to the mine’s life. Chairman of the Board OUR SOCIAL AND ENVIRONMENTAL COMMITMENT 1 2 3 4 1. Caylloma Mine viewing north 2. Caylloma Mine: Caylloma community site visit 3. San Jose Project: San Jose artisans 4. San Jose Project: Ocotlan community students site visit RESPECT AND Fortuna’s philosophy is to build and maintain collaborative ETHNOCULTURAL relationships wherever we have operations. We know that DIVERSITY mining and exploration affects people, communities and the environment. What those impacts are, and the legacies they leave, are up to us. That is why we strive to improve living conditions in the neighborhoods we operate and leave as small of a footprint as possible. In Peru and Mexico, the Company coordinates closely with government environment agencies and works diligently to comply with all regulations to ensure minimal impact on the environment. Our community relations programs are based on respect for ethnocultural diversity, open communication and effective interaction with all stakeholders. The Company also works with communities towards self-development of economically sustainable activities to improve their quality of life. In the Caylloma region of Peru, the Company conducts technical and environmental awareness workshops, assists in improving educational programs, alpaca breeding and feeding practices amongst various other activities. At the San Jose Project in Mexico, we conduct regular project briefings with the community along with local, state and federal authorities. The Company is also conducting health and environmental workshops, assisting in the development of local schools´ infrastructures and participating in a collaborative manner in the sustainability of community social programs. 2 1 / 1 1 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F CAYLLOMA MINE: LOW COST PRODUCER, CONSISTENT CASH GENERATION 1 2 3 1. Caylloma Mine: Animas Vein 2. Caylloma Mine 3. Caylloma Mine: 1,200 tpd milling circuit PROFITABLE SINCE OPENING Fortuna’s 100%-owned Caylloma Mine is a low-cost, under- ground vein mine producing zinc, lead-silver-gold and copper- silver-gold concentrates. The mine and related concessions cover more than 10,000 hectares in Arequipa, located in the southern highlands of Peru. Fortuna acquired the former producer in 2005 and returned it to production a year later. The mine has operated profitably since opening. Exploration and development are ongoing and an updated reserve and resource estimation will be produced in 2010. Caylloma Reserve and Resource Table CATEGORY Proven & Probable Measured & Indicated* Inferred* Tonnes (M) 4.0 0.3 1.3 Ag (g/t) 156 64 187 Au (g/t) 0.6 0.3 0.3 Zn (%) 2.6 2.2 3.3 Pb (%) 1.7 1.2 1.9 Ag (M oz) 20.3 0.6 7.7 * Based on a cutoff of US$ 37.15/t. Reserves estimate is based on a cutoff of US$ 47.80/t. Mineral Resources do not include Reserves. SIGNIFICANT INCREASE IN PRODUCTION AND REVENUES IN 2009 Gross revenues from Caylloma, at US$51.43 million, increased 107% over 2008 revenues of US$24.87 million. This increase in revenue is explained by higher metal prices, processing plant expansion, improvements in metal recoveries and higher average grades. 2009 silver output increased 109% from 805,057* ounces in 2008 to 1,682,546** ounces. The mine achieved its planned expansion to 1,200 tpd, and production is expected to stabilize for all metals except copper. A new copper circuit, commissioned in the fourth quarter of 2009, will add 1 million pounds of copper to the production mix in 2010. Silver production is forecast to reach 1,700,000 ounces in 2010 accounting for approximately 45% of revenue. Silver production is currently forecast to reach 1,700,000 ounces in 2010, although mining of high grade ore from the new discovery on the upper levels of the Animas Vein may advance Caylloma´s silver production to the 2 million ounce per year benchmark, approximately 45 to 50% of revenue. (*) Silver production contained in lead concentrate (**) Silver production contained in lead and copper concentrates 4 1 / 3 1 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F  Commodities: Silver, Zinc, Lead, Gold, Copper Location: Arequipa, Peru (Latitude: 15° 13” S, Longitude: 71° 49” W) Ownership: 100% Deposit Type: Intermediate-sulfidation epithermal deposit Status: - Mine and Processing Plant operating at 1,200 tpd - Conducting exploration activities for high-grade silver veins CAYLLOMA MINE: LOW COST PRODUCER, CONSISTENT CASH GENERATION 2010 Production Guidance MEDAL PRODUCTION 2010 (FORECAST) Silver (oz) Zinc (lb) Lead (lb) Copper (lb) 1,700,000 28,400,000 25,200,000 1,000,000 SILVER GRADES IMPROVING Silver grades continued to improve in 2009, due to the addition of high-grade ores from the Bateas and Soledad veins. The head grade for silver averaged 155 g/t in 2009, a 63% increase over the 2008 average of 95 g/t. LOWER COSTS, HIGHER MARGINS Caylloma’s cash costs per ounce of silver, net of by-products, continued a downward trend, reaching negative US$4.93/oz compared with negative US$3.78/oz in 2008. The mine’s operating margin for 2009 was US$78.00 per tonne of ore compared to US$40.59 for 2008, an increase of US$37 per tonne of processed ore. The Net Smelter Return per tonne of processed ore was US$124 in 2009 compared to US$87 in 2008. Unit cash costs per tonne of processed ore were US$46.00 in 2009 compared to US$46.41 in 2008. Process plant improvements, higher grades and higher mill throughput all contributed to the improved mine performance. EXPLORATION AND DEVELOPMENT FOR FUTURE PRODUCTION Following the economic downturn in 2008, management modified its short-term focus to mine development and expansion while de-emphazing exploration activities. This strategy was designed to increase revenues and operating efficiencies. As market conditions improved in 2009, along with dramatically higher throughput and revenues at Caylloma, Fortuna is investing more in exploration and resource expansion. Exploration raises and cross-cuts along the upper portion of the Animas Vein (see Animas Vein longitudinal section below) late in the year cut high grade silver-gold mineralization above level 6. All production to date from the Animas Vein, source of 85% of Caylloma’s mill feed, has 6 1 / 5 1 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F 1 2 1. Caylloma Mine: High-grade silver ore, Soledad Vein 2. Caylloma Mine: Animas Vein been derived from beneath the 6th level. Grades from Raise CH 418N returned an average of 1,890 g/t Ag and 5.4 g/t Au over an average sample width of 1.35 meters, while Cross-Cut 418N averaged 2,110 g/t Ag and 13.27 g/t Au over a true width of 4.36 meters. Animas Vein - Longitudinal Section (Looking NW) TJ 388E TJ 400E TJ 415W TJ 415E Other targets at Caylloma provide additional potential for resource and reserve expansion. Exploration drilling of the Don Luis II Vein prospect, located in the western portion of the Caylloma District, was initiated in May of 2010 where surface sampling and mapping have identified mineralized structures with silver and gold mineralization. SAN JOSE PROJECT: FORTUNA´S NEXT MINE 1 2 3 1-3. San Jose Project: Main access decline construction activities POSITIVE PRE-FEASIBILITY, Subsequent to year end, on April 26, 2010, CONSTRUCTION BEGINS Fortuna released the results of a positive Pre-Feasibility Study (PFS) for the San Jose Project. This study sets the basis for construction of the Company’s second mine with the goal of commencing production in the third quarter of 2011. ANNUAL PRODUCTION: 4.9M OUNCES SILVER EQUIVALENT The PFS study considers 4.5 years to reach the design capacity of 1,500 tpd and a 9 year mine life. At the 1,500 tpd production rate, San Jose will produce 4.9 million silver equivalent ounces annually at a cash cost of US$6.20 per silver equivalent ounce, generating annual revenues of US$60 million and EBITDAs of US$40 million at projected metal prices of US$15/oz for silver and US$900/oz for gold. Mineral Reserve Summary Reserve Category Probable Diluted Tonnes (000) 3,516 Ag Eq Dil (g/t) 303 Ag Dil (g/t) 205 Au Dil (g/t) 1.6 Ag Eq (oz) (000) 34,202 Ag (oz) (000) 23,213 Au (oz) (000) 181 Contained Metal Mineral Resource Summary* Reserve Category Indicated Inferred Tonnes (000) 3,478 3,074 Ag Eq (g/t) 364 334 Ag (g/t) 246 222 Au (g/t) 1.9 1.8 Ag Eq (oz) (000) 40,725 32,963 Ag (oz) (000) 27,486 21,988 Au (oz) (000) 215 178 Contained Metal (*) 100 g/t Ag Eq Cutoff, inclusive of Mineral Reserves CHALLENGES OF RESOURCE CONVERSION IN A VEIN DEPOSIT The PFS presented challenges due to the limitations a vein deposit imposes on resource conversion. Although extensive in-fill drilling on 30-meter spacing was completed in the upper half of the deposit, only 53% of the total estimated resources or 3.5Mt at a 100 g/t Ag Eq 8 1 / 7 1 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F  Commodities: Silver, Gold Location: Taviche Mining District, Oaxaca, Mexico (Latitude: 16° 41” N, Longitude: 96° 42” W) Ownership: 100% Deposit Type: High-grade, low-sulfidation Ag-Au epithermal deposit Status: - Pre-feasibility study completed - Construction of a 1,500 tpd mine initiated Q2 2010 - Exploration of property holdings in-progress SAN JOSE PROJECT: FORTUNA´S NEXT MINE cutoff are in the indicated classification with 3.1Mt remaining in the inferred classification. Approximately 2.8Mt of inferred resources above the break-even cutoff grade are located within the immediate area of the mineable reserves and will be developed in conjunction with the modeled mineable reserves. Approximately 800,000 tonnes grading 314 g/t Ag Eq and containing 8M ounces of equivalent silver are located above the 1,300m level within the reserve area planned for production in the initial four years of operation. These resources will be accessed through the same mine development already anticipated for the stated mineable reserves and their inclusion into the mine plan will allow for a quicker ramp-up to the design capacity of 1,500 tpd at lower capital expenditure rates than permitted within the constraints of the PFS. CONSERVATIVE APPROACH EXCLUDES 5M SILVER EQUIVALENT OUNCES Approximately 400,000 tonnes of mineralized material containing an estimated 5 million silver equivalent ounces are located in the upper 100 meters of the deposit where historic mining has taken place. Due to uncertainty in the exact location and volume of existing workings above the 1450m elevation, these materials have not been included in the reported resource and reserve inventories for the deposit. As the mine is developed, it is management’s expectation that a significant portion of these mineralized materials will be converted to mineable reserves. KEY GOAL: FAST TRACK TO DESIGN CAPACITY AT LOWER CAPITAL INVESTMENT RATE Based on the opportunities presented through incorporation of the inferred resources and other mineralized materials into the mine plan, the Company believes that the design capacity of 1,500 tpd can be achieved within a shorter time period than considered in the PFS. Inclusion of these materials into the mine plan will result in a significant extension to the life of the mine and will directly reduce the rate of capital investment required for underground development on an annualized basis. FAVORABLE RETURNS PROJECTED The PFS for the San Jose Project indicates an after-tax internal rate of return of 18% and an NPV of US$36 million at a discount rate of 8%. The Company believes that there is substantial opportunity for improvement of the project economic metrics that will be realized as the project is developed and enters into production 0 2 / 9 1 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F 1 1. San Jose Project: Plant and top soil removal at tailings site 2. San Jose Project: Ocotlan grey water treatment facility 3. San Jose Project: Main access decline construction activities 2 3 SILVER ANALYSIS AND OUTLOOK TOTAL FABRICATION DEMAND FOR SILVER IN 2009: 608.8 MILLION OUNCES EXCHANGE TRADED FUNDS’ PHYSICAL SILVER HOLDINGS 18% Photography 112.3 40% Jewelry & Silverware 242.1 ZKB ETF SLV CEF SIV ETF Australia MM Ozs 500 450 400 350 300 250 200 150 100 50 0 Source: CPM Group Source: CPM Group 2002 2006 2007 2008 2009 2010 OPPOSING MARKET FORCES PUSH Silver’s average price of US$14.67/oz in 2009 SILVER LOWER IN 2009 was 2% lower than the 2008 average of US$14.97. reached US$17.50/oz. Silver’s performance in 2009 was in some respects a repeat of 2008, meaning that its dual identity as both a precious and industrial metal exerted opposing forces By the end of Q1 2010, however, the price had on the demand and price trajectory. NEAR RECORD INVESTMENT DEMAND—AGAIN The predominant influence on silver by far was the second consecutive year of near-record high investment demand. Despite silver’s primary role as an industrial metal, its appeal as a safe haven investment continued to grow. Sovereign debt problems, inflation threats and rising interest rates were a few of the factors that pushed investors to buy unprecedented amounts of both physical silver (coins and ingots) and shares of silver ETFs. Sales of U.S. Mint Silver Eagle coins totaled 28.8 million ounces in 2009, a 47.4% increase over the previous year. Worldwide coin sales were estimated by CPM Group at 35 million ounces. At the end of 2009, silver ETF holdings stood at an all-time high of 464.8 million ounces, up 48.1% from 2008. As economic worries continue, particularly related to the sovereign debt situation and threats of inflation, investment buying of silver will likely remain strong through 2010. 22% Other Uses 134.9 20% Electronics & Batteries 119.5 2 2 / 1 2 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F SLUGGISH ECONOMIES AND DECLINING INDUSTRIAL DEMAND Overall silver demand was tempered in 2009 by continued sluggish fabrication demand. The ongoing decline in photography film use accounted for much of this drop. However, a world still emerging from a major recession simply was not buying as many silver-related goods. CPM Group estimates that fabrication demand fell to 616.4 million ounces in 2009, an 11.3% decline from 2008. An improving economic outlook, however, should translate into higher fabrication demand in 2010. Certain sectors, including electronics and batteries, solar panels and chemical catalysts, are already showing higher sales over 2009. HIGHER PRICES BRING ON NEW SUPPLY The relatively high prices for silver throughout 2009 and into 2010 generated a supply increase of 2.4% over 2008, to a record high 826.1 million ounces, sustaining a 15-year upward trend in both mine and scrap supply. Mine output, at 554 million ounces, accounted for most of the increase. Mine supply is expected to exceed 580 million ounces in 2010 as high prices bring new mines on stream and generate more production from existing mines. New supply was augmented in 2009 from a 7% increase in secondary scrap—mostly jewelry, silverware, photo- graphic materials, electronics and batteries. PERU REMAINS NUMBER ONE SILVER PRODUCER IN THE WORLD Peru remained the world’s key supplier of silver in 2009, producing a record high 123.9 million ounces in 2009—a 4.6% increase over 2008. Peru’s silver production has risen sharply over the past decade and it has surpassed Mexico as the world’s number one silver producer. The coun- try is estimated to hold 13% of the world’s entire silver reserves. MEXICO OUTPUT TO RISE DRAMATICALLY Mexico held its number two spot, producing 104.7 million ounces and increasing 0.6% over 2008. Like Peru, Mexico’s silver output has increased steadily over the past several years. How- ever, silver production in Mexico is expected to rise nearly 15% in 2010—a dramatic increase generated in part by the planned startup of Goldcorp’s massive Peñasquito Mine. *Based on information supplied by CPM Group COPPER, LEAD, ZINC ANAYLSIS AND OUTLOOK ALL PRICES UP DRAMATICALLY Copper, lead and zinc were among the strongest performers in the commodity complex in 2009. LME three-month official copper prices rose 136% in 2009 while lead (LME three-month) and zinc (LME three-month) prices gained 134% and 107%, respectively. At the end of 2009 copper stood at US$7,377 per metric tonnes (Mt), just 16% below its record high of US$8,812 set in July 2008. Significant recoveries were also staged in lead and zinc, which closed the year at US$2,416 and US$2,596 per Mt, respectively. CHINA AFFECTING ALL BASE METALS MARKETS China’s growing economy is significantly impacting the price of all base metals. In 2009, China’s economy achieved an overall rebound and recovery with annual GDP growth of 8.7%. Not only is China the largest consumer and producer of all unwrought base metals, for most of 2009 it was a net importer of all base metals.** Chinese imports of copper, lead and zinc rose to record highs on the back of the Chinese government stockpiling program and restocking by Chinese consumers. Significant arbitrage opportunities and reduced availability of scrap also amplified import demand of base metals. Global Market Share of Chinese Demand CHINA CONSUMPTION TRENDS Percentage 2000 2009 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% LEAD ZINC COPPER WILL CONTINUE TO SUPPORT METALS Chinese domestic demand for many final goods is still at a nascent stage. If the trend in vehicle ownership per capita in the United States foreshad- ows expenditure habits in China, Chinese motor vehicle ownership may be set to increase more than three and a half fold over the next 10 years. Last year the number of motor vehicles relative to popu- lation in China was at similar levels to those seen in the United States in 1917. Automobiles employ lead in their lead-acid batteries and zinc in the die castings for emblems, moldings, door handles and brackets. Zinc is also a protective alloy coating in galvanized steel used for automobile body parts. * Based on information supplied by CPM Group **China was a net exporter of unwrought aluminum in December 2008. 4 2 / 3 2 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Financial Reports pg.25 pg.55 pg.56 pg.57 MANAGEMENT’S DISCUSSION AND ANALYSIS CONSOLIDATED BALANCE SHEETS CONSOLIDATED STATEMENTS OF OPERATIONS CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) pg.58 pg.59 pg.60 pg.88 CONSOLIDATED STATEMENTS OF CASH FLOWS CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS CORPORATE INFORMATION FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the sig- nificant factors that have affected Fortuna Silver Mines Inc. and its subsidiaries’ (“Fortuna” or the “Company”) performance and such factors that may affect its future performance. For a comprehensive understanding of Fortuna’s financial condition and results of operations, this MD&A should be read in conjunction with the Company’s audited consolidated financial statements for year ended December 31, 2009 and the related notes contained therein. The Company reports its financial position, results of operations and cash flows in accordance with Canadian generally accepted accounting principles (“Canadian GAAP”). In addition, the following should be read in conjunction with the Consolidated Financial Statements of the Company for the year ended December 31, 2008, the related MD&A, and Fortuna’s Annual Information Form (available on SEDAR at www.sedar.com). This MD&A refers to vari- ous non-GAAP measures, such as cash cost per tonne of processed ore, cash cost per ounce of payable silver, adjusted net income (loss), cash generated by operating activities before changes in working capital, used by the Company to manage and evaluate operating performance and ability to generate cash and are widely reported in the silver mining industry as benchmarks for performance. Cash costs are presented as they represent an industry standard method of comparing certain costs on a per unit basis. The Company believes that certain investors use these non-GAAP measures to evaluate the Com- pany’s performance. Non-GAAP measures do not have standardized meaning. Accordingly, non-GAAP measures should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP. To facilitate a better understanding of these measures as calculated by the Company, we have provided detailed descriptions and reconciliations where applicable. This MD&A is prepared as of March 11, 2010. Certain statements contained in this MD&A and elsewhere constitute forward-looking statements. Such forward-looking statements involve a number of known and unknown risks, uncertainties and other factors which may cause the actual results, and performance of achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, changes in project parameters to deal with unanticipated economic factors, risks related to technological and operational nature of the Company’s business, the speculative nature of exploration and development, and changes in local and national government legislation. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statements were made, and readers are advised to consider such forward-looking statements in light of the risks set forth in the section Risks and Uncertainties. This MD&A also contains references to estimates of mineral reserves and mineral resources. The es- timation of reserves and resources is inherently uncertain and involves subjective judgments about many relevant factors. The accuracy of any such estimates is a function of the quantity and quality of available data, and of the assumptions made and judgments used in engineering and geological interpretation, which may prove to be unreliable. There can be no assurance that these estimates will be accurate or that such mineral reserves and mineral resources can be mined or processed profitably. FORWARD LOOKING INFORMATION 5 2 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated Mineral resources that are not mineral reserves do not have demonstrated economic viability. Except as required by law, the Company does not assume the obligation to revise or update these forward looking statements after the date of this document or to revise them to reflect the occurrence of future unanticipated events. In particular, forward-looking information and statements include: • “A pre-feasibility study covering all pre-construction engineering projects for the mine, processing plant and supporting infrastructure is scheduled to be completed in the first quarter of 2010, with construction activities to commence shortly thereafter.” (page 28); • “The ore mix in 2010 is expected to be similar.” (page 32); • “In 2010, 14,800 m of development and preparation have been budgeted as part of ongoing operations.” (page 32); • “The first phase of the project will demand $2.5 million and construction is scheduled for the second quarter of 2011.” (page 32); • “The Company expects to publish a pre-feasibility and start construction activities during the first quarter of 2010. The Company looks forward to commissioning San Jose in 2011, which will drive further growth in Fortuna’s silver production.” (page 34); • “The new resource estimate will serve as the basis for pre-feasibility level engineering studies projected for the first quarter of 2010.” (page 34); • “The Company´s engineering staff is currently conducting an internal review of the various engineering projects and continues to work towards the delivery of the final feasibility study by the first quarter of 2010.” (page 36); • “Management believes the Company’s cash position as well as its ongoing operation in Caylloma is sufficient to support the Company’s operating and capital requirements on an ongoing basis.” (page 38); • “For 2010, the Company expects to sustain silver production at 1,700,000 ounces, with base metal production also remaining level at current rates.” 2010 Production Guidance table. (page 53). BUSINESS OF THE COMPANY Fortuna Silver Mines Inc. (the “Company”) is a mining company focused on producing silver and devel- oping silver projects in Latin America. The Company’s principal assets are the Caylloma Polymetallic Mine in southern Peru and the San Jose Silver-Gold Project in southern Mexico. RECENT DEVELOPMENTS AND 2009 HIGHLIGHTS Financial and Operating Results During the year ended December 31, 2009, the Company generated record sales of $51.43 million compared to $24.87 million in 2008, representing an increase of 107%. In 2009, Caylloma produced 1,682,546 ounces of silver, representing an increase of 109% over the 2008 production of 805,057 ounces of silver. This increase is primarily attributable to a 64% increase in silver head grade. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RECENT DEVELOPMENTS AND 2009 HIGHLIGHTS (continued) The income in 2009 of $0.62 million (2008: loss $0.91 million) was due primarily to record sales of $51.43 million (2008: $24.87 million) resulting in record mine operating income of $27.73 million (2008: $3.90 million) offset by losses on our commodity hedge book. The Company’s base metal price protection program generated a loss on commodity contracts of $7.36 million during 2009 compared to a gain of $4.27 million in 2008. Adjusting for the mark-to-market effect on the loss on commodity contracts, a non-GAAP measure, the year of 2009 resulted in adjusted net income of $1.98 million compared to a loss of $1.30 million in 2008. NET (LOSS) INCOME FOR THE PERIOD Items of note, net of tax: Mark to Market effect on derivatives ADJUSTED NET INCOME (LOSS) FOR THE PERIOD(1) (1) A non-GAAP measure Expressed in millions Years ended December 31, 2009 0.62 $ $ $ 1.36 1.98 $ 2008 (0.91) (0.39) (1.30) Cash generated by operating activities before changes in working capital, a non-GAAP measure, for the year was $15.91 million up from $8.65 million in 2008. During the year ended December 31, 2009, silver production amounted to 1,755,017 ounces with a negative cash cost per ounce of payable silver of $4.93, net of by-product credits. In 2009, 395,561 tonnes of ore were treated compared to 331,380 tonnes in the prior year and the cash cost per tonne of treated ore was $46.00 (Cash cost is a non-GAAP measure). See page 37 for reconciliation of cash cost to the cost of sales in the consolidated statement of operations. Financing On January 6, 2010, the Company signed a commitment letter to enter into a $20 million senior se- cured revolving credit facility with The Bank of Nova Scotia. The facility has a 2.5 year maturity. The proceeds of the facility may be used for general corporate purposes, including the development of the San Jose Project in Mexico. The facility is intended to complement Fortuna’s strong cash position and provide additional financing flexibility during the construction stage at San Jose. No funds have been drawn under this facility. On February 3, 2010, the Company entered into a bought deal financing (“Offering”) with a syndicate of underwriters co-led by CIBC and Canaccord Financial Ltd. The Offering closed on March 2, 2010 and the Company issued 15,007,500 common shares at a price of CAD$2.30 per shares (refer to Note 16.a) under the bought deal financing for gross proceeds of CAD$34.5 million. Net proceeds of CAD$32.8 million after underwriting fees of CAD$1.7 million were raised from the bought deal financing. 7 2 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated The Company intends to use the net proceeds from the Offering to partially fund the construction of its 100% owned San Jose project in the state of Oaxaca, Mexico and for general corporate purposes. Approval of Change of Land Use for San Jose Project, Mexico On December 14, 2009, the “Secretaria de Medio Ambiente y Recursos Naturales” (Mexican Envi- ronmental Agency) approved the Company’s application for a change of land use from agricultural to industrial for the San Jose silver-gold project, located in the southern State of Oaxaca, Mexico. This is the final permit required to commence construction activities and complements the Environ- mental Impact Study, which was approved in late October 2009. A pre-feasibility study covering all pre-construction engineering projects for the mine, processing plant and supporting infrastructure is scheduled to be completed in the first quarter of 2010, with construc- tion activities to commence shortly thereafter. Exchange Listings The Company’s common shares began trading on the Toronto Stock Exchange (TSX) at the opening of trading on Monday, January 18, 2010 under the symbol “FVI”. Discovery of high-grade silver-gold at Caylloma Mine, Peru On February 2, 2010, the Company announced the discovery of high-grade silver-gold mineralization in the upper portion of the Animas Vein at the Caylloma Mine in southern Peru. The Animas vein, traditionally a polymetallic vein, is the source of 85% per cent of production at the Caylloma mine. The Company is currently investigating the impact of the new discovery and are working to define resources to be included in the mine plan. SELECTED ANNUAL INFORMATION Expressed in $000’s, except per share data Sales Income before income taxes and non-controlling interest Net income (loss) Earnings (loss) per share, basic and diluted Total assets Long term liability 2009 51,428 6,312 623 0.01 Years Ended December 31, 2008 24,867 687 (910) (0.01) 2007 29,796 1,566 (2,437) (0.04) 139,738 115,368 126,860 1,454 1,382 411 In 2009, the Company generated record sales of $51.43 million compared to $24.87 million in 2008. This increase was primarily driven by higher silver and lead head grades, in particular silver which increased by 64%, higher throughput, and reduced treatment charges. Sales in 2008, decreased from 2007, by 16.5% in spite of higher metal production due to decreased unit values of concentrates comprised of decreases in metal prices and increases in smelter treatment charges. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated QUARTERLY INFORMATION The following table provides information for the eight fiscal quarters ended December 31, 2009: Expressed in $000’s, except per share data Quarters Ended Sales Mine operating income (loss)* Net income (loss) Earning (loss) per share - basic - diluted 31-Dec-09 30-Sep-09 30-Jun-09 31-Mar-09 31-Dec-08 30-Sep-08 30-Jun-08 31-Mar-08 6,808 13,230 12,862 8,980 2,795 7,492 7,772 16,356 10,376 1,037 0.01 0.01 7,074 (556) (0.01) (0.01) 6,792 1,196 3,487 (1,054) (2,986) (2,468) 0.01 0.01 (0.02) (0.02) (0.03) (0.03) 1,734 (297) 0.00 0.00 2,848 2,493 0.03 0.03 2,303 (638) (0.01) (0.01) * Mine operating income (loss) is a non-GAAP measure used by the company as a measure of operating performance. Sales have consistently increased quarter over quarter since the fourth quarter of 2008 with the fourth quarter of 2009 reaching a record high at $16.36 million. This upward trend in sales is mainly at- tributable to increases in metal prices. Higher sales throughout 2009 compared to the corresponding quarters of 2008 have been significantly driven by higher silver head grades, higher production, and lower treatment charges. FINANCIAL RESULTS During the year ended December 31, 2009, the Company generated record sales of $51.43 million compared to $24.87 million in 2008, representing an increase of 107%. When broken down by type of concentrate: silver-lead concentrate sales increased in tonnage by 50%, and the unit value of concentrate increased by 11%. The latter increase is a result of lower smelter treatment charges of $197 per ton of concentrate and higher silver grade offset by a 18% and 2% decrease in lead and silver prices, respectively. Zinc concentrate sales increased in tonnage by 23% and the unit value of concentrate increased by 4%. The latter increase is a result of lower smelter treatment charges of $140 per ton of concentrate offset by a 12% decrease in the metal price. During the year ended December 31, 2009, mine operating income was $27.73 million, 6 times above the $3.90 million achieved in the same period of 2008. This improvement is a reflection of improved head grades, higher throughput, increased recoveries, and better commercial terms. Contributing negatively to the income for the year of $0.62 million (2008: loss $0.91 million) is primarily the non- operating loss in commodity contracts of $7.36 million (2008: gain $4.27 million). Mark-to-Market effect: Included in the $7.36 million loss recorded on commodity contracts, is a mark- to-market effect of $1.36 million, net of tax, related to open contracts as at the end of December 2009 expiring between the months of January 2010 and December 2010. Total cost of sales, including depletion, depreciation and accretion, in 2009 totalled $23.70 million (2008: $20.97 million) and represents an increase of 13% over 2008. While tonnage of concentrate sold during 2009 increased 35% compared to 2008, cost of sales increased only by 13%. Lead and silver head grades increased by 25% and 64%, respectively, over 2008. Other things being equal, an increase in head grades will deliver higher concentrate production for equal or similar production costs. 9 2 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated Selling and administrative expenses in 2009 increased 22% to $9.56 million (2008: $7.82 million). The increase is due mainly to higher selling expenses associated with higher tonnage of concentrate sold. Corporate general and administrative expenses increased by $0.67 million to $4.06 million (2008: $3.39 million); selling and administrative expenses increased by $0.81 million to $5.01 mil- lion (2008: $4.20 million); and government royalty paid by Minera Bateas increased by $0.26 million to $0.49 million (2008: $0.23 million). Stock-based compensation charge totalled $2.71 million compared to $1.35 million in 2008. Interest and other income and expenses in 2009 amounted to net income of $0.43 million compared to net income of $1.36 million in 2008. The decrease is attributable to the Company holding a com- paratively smaller average cash balance and a reduction in interest rates. Interest and finance expenses in 2009 were $0.16 million compared to $0.10 million in 2008. Inter- est expenses relate primarily to capital lease operations at our operating subsidiary. Net loss on commodity contract in 2009 amounted to $7.36 million compared to a net gain of $4.27 million in 2008. This amount reflects the change in fair value of derivative contracts between the opening of the reporting period and either the expiry of the contracts or the closing of the period, whichever happened first. Included in the $7.36 million loss recorded on commodity contracts, is a mark-to-market effect of $2.17 million ($1.36 million net of tax) related to open contracts as at the end of December 2009 expiring between the months of January 2010 and December 2010. The Com- pany has entered into short term commodity forward and option contracts to secure a minimum price level on part of Caylloma’s zinc and lead metal production, and enters regularly into forward lead and zinc contracts with banks to fix the final settlement price of metal delivered in concentrates, where the final settlement price is yet to be set at a future quotational period according to contract terms. The Company does not use hedge accounting. The $5.87 million Income tax provision recorded for 2009 (2008: $1.70 million) comprises current and future income tax expense. Current income tax for the period, including the worker profit sharing plan regulated by Peruvian law was $5.08 million (2008: $nil). Future income tax expense, amount- ing to $0.79 million (2008: $1.70 million) is attributed to temporary differences arising on amounts of mineral properties at Peruvian operations where exploration and development are expensed for tax purposes. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RESULTS OF OPERATIONS Peru - Caylloma Ag-Pb-Zn Mine Caylloma Mine Tonnes milled Average tons milled per day Head Grade Silver (g/t) Lead (%) Zinc (%) Copper (%)* Recoveries Silver (%)** Lead (%) Zinc (%) Copper (%) * Production (metal contained) Silver (oz)*** Lead (lbs) Zinc (lbs) Copper (lbs)* Average Selling Price Silver (US$ per oz) Lead (US$ per lb) Zinc (US$ per lb) Copper (US$ per lb)* Unit cash cost and Net smelter return Unit cash cost (US$/oz ag) Unit Net Smelter Return (US$/tonne) * Copper figures for the month of December 2009 ** Silver recovery in lead and copper concentrates *** Silver production contained in lead and copper concentrates Years ended December 31, 2008 331,381 936 2009 395,560 1,121 154.76 3.10 3.66 0.24 85.40 93.02 89.07 51.94 94.58 2.48 3.65 na 79.47 90.69 87.39 na 1,682,546 25,137,107 28,441,836 88,185 805,057 16,501,600 23,283,019 na 14.65 0.78 0.75 3.17 (4.93) 124.00 15.02 0.95 0.85 na (3.78) 87.00 In 2009, the Caylloma mine increased throughput by 19% compared to 2008 by processing 395,560 tonnes of ore, and surpassed its silver production forecast by 5%. Production in 2009, as compared to 2008, increased as follows: • silver production increased by 109% to 1,682,546 ounces; • lead metal production increased by 52% to 25,137,107 pounds; • zinc metal production increased by 22% to 28,441,836 pounds; and, • exceeded the Company’s silver production forecast of 1.6 million ounces by 5%. 1 3 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated Increments against 2008 were achieved through a combination of higher grades, improved metallurgi- cal recoveries, and a higher throughput which reached an average of 1,121 tonnes per day (“tpd”) in 2009, 20% above the average throughput rate of 936 tpd in 2008. Mine production throughout the year took place principally on the polymetallic Animas vein which pro- vided 85% of ore sourced to the mill in 2009. The balance was sourced as follows: 9% from high grade silver veins Soledad and Bateas, and 6% from existing ore stocks. The ore mix in 2010 is expected to be similar. Total underground preparation and development in 2009 amounted to 9,800 m, below the 13,000 m drifted in 2008. The gradual return to normality in metal prices throughout the year allowed the Company to get back on track with respect to required mine development after the significant budget cutbacks at the end of 2008 and the beginning of 2009. In 2010, 14,800 m of development and preparation have been budgeted as part of ongoing operations. In 2009, the Company successfully commissioned the expansion project that allowed a ramp up in plant capacity to 1,200 tpd and the addition of a copper circuit. The copper project started commer- cial production in December of 2010 and is now operating at sustained recoveries of 56%. In 2009, the Company completed the feasibility study for a new tailings facility. Total estimated capital for the project is $6.8 million for a capacity equivalent to 15 years of operations. The first phase of the project will demand $2.5 million and construction is scheduled for the second quarter of 2011. Cash cost per ounce of payable silver net of by-product credits at Caylloma was negative $4.93 in 2009, a 30% drop compared to 2008 (2008: negative $3.78) attributable to a 45% increase in by- product credits and a 108% increase in payable silver ounces. Cash cost per tonne of treated ore in 2009 decreased by 1% to $46.00 (2008: $46.41). (See page 37 for reconciliation of cash production cost to the cost of sales in the consolidated statement of operations). On July 16, 2009, the Company released an updated NI 43-101 resource estimation for Caylloma. The NI 43-101 Technical Report was filed on August 27, 2009. Highlights of the resource & reserve estimation include: • Proven and Probable Mineral Reserves are estimated at 4.03 million tonnes averaging 156 g/t Ag, 0.55 g/t Au, 1.70% Pb and 2.58% Zn; • Contained silver is estimated at 20.3 million ounces, representing a 304% increase in silver ounces in the Proven and Probable reserve categories over the previous resource and reserve estimate (NI 43-101 Technical Report published October 3, 2006); • Inferred Mineral Resources are estimated at 1.3 million tonnes averaging 187 g/t Ag, 0.29 g/t Au, 1.92% Pb and 3.25% Zn; • Contained silver in the Inferred Resource category is estimated at 7.7 million ounces. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RESULTS OF OPERATIONS (continued) Discovery of high-grade silver-gold at Caylloma Mine, Peru On February 2, 2010, the Company announced the discovery of high-grade silver-gold mineralization in the upper portion of the Animas Vein at the Caylloma Mine in southern Peru. The Animas vein, tra- ditionally a polymetallic vein, is the source of 85% per cent of production at the Company’s Caylloma mine. The Company is currently investigating the impact of the new discovery and are working to define resources to be included in the Company’s mine plan. Price protection program During the year, the Company entered into commodity forward and option contracts to secure a mini- mum price level on part of its Caylloma’s zinc and lead metal production throughout the period covering February 2009 to December 2010 with the objective of securing short term capital requirements for project development. The counterparties are Standard Bank PLC, Banco Bilbao Vizcaya Argentaria, S.A., Macquarie Bank Limited, Goldman Sachs, and Scotia Bank. Forward Sales Contracts - Swap Basis The contracts are spread evenly over the periods shown below with settlement occurring on a monthly basis. No initial premium associated with these trades has been paid. The following forward sale contracts were entered into on a SWAP basis, as defined below: January 2009 - settlements throughout February 2009 to July 2009: Lead forward contracts: $1,109/t, for the total of 3,150 tons Zinc forward contracts: $1,240/t, for the total of 3,850 tons July 2009 - settlements throughout August 2009 to December 2009: Lead forward contracts: $1,645/t, for the total of 2,675 tons Zinc forward contracts: $1,561/t, for the total of 3,000 tons August 2009 - settlements throughout January 2010 to June 2010: Lead forward contracts: $1,910/t, for the total of 1,800 tons Zinc forward contracts: $1,787/t, for the total of 1,050 tons The SWAP basis contracts are settled against the arithmetic average of zinc and lead spot prices over the month in which the contract matures. Put and Call Option Commodity Arrangements As at December 31, 2009, the Company had entered into a series of put and call option commodity arrangements. A long put refers to put options that have been bought by the Company, and a short call refers to call options that have been sold by the Company. Settlement of these options occurs monthly during the period of January 2010 to December 31, 2010 as follows: 3 3 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated Period January 2010 - June 2010 The following Zinc Option contracts were entered into: • 6 Long put options at strike price: • 6 Short call options at strike price: $2,000/t, for the total of 2,100 tons $3,010/t, for the total of 2,100 tons The following Lead Option contracts were entered into: • 6 Long put options at strike price: • 6 Short call options at strike price: $2,000/t, for the total of 1,200 tons $2,975/t, for the total of 1,200 tons Period July 2010 - December 2010 The following Zinc Option contracts were entered into: • 6 Long put options at strike price: • 6 Short call options at strike price: $2,000/t, for the total of 3,150 tons $3,010/t, for the total of 3,150 tons The following Lead Option contracts were entered into: • 6 Long put options at strike price: • 6 Short call options at strike price: $2,000/t, for the total of 2,850 tons $2,974/t, for the total of 2,850 tons Mexico - San Jose Silver-Gold Project With the recent granting of the Change of Land Use permit (see Fortuna news release dated December 14, 2009), Fortuna now has all of the key permits necessary to start construction at San Jose. Proj- ect staffing for the construction phase is being conducted and the Company has initiated selective searches for long lead equipment. The Company expects to publish a pre-feasibility and start construction activities during the first quar- ter of 2010. The Company looks forward to commissioning San Jose in 2011, which will drive further growth in Fortuna’s silver production. For financing of this project, refer to Liquidity and Capital Resources (page 38). Trinidad Resource Estimation On October 26, 2009, the Company released an updated NI 43-101 resource estimation for San Jose, with the full NI 43-101 released on December 10, 2009. Highlights are as follows: Indicated Resources have increased 83% to 2.69 million tonnes with contained silver equivalent ounc- es increasing 112% to 37.6 million Ag Equivalent1 ounces. Silver and gold grades in the Indicated Resource category have increased by 12% to 295 g/t and 4% to 2.27 g/t, respectively. The new re- source estimate will serve as the basis for pre-feasibility level engineering studies projected for the first quarter of 2010. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RESULTS OF OPERATIONS (continued) At a cut-off grade of 150 g/t Ag Equivalent, the Indicated and Inferred Mineral Resources for the Trini- dad Zone at San Jose are estimated at: Indicated Mineral Resource: 2.69 million tonnes grading 295 g/t Ag and 2.27 g/t Au containing 37.6 million Ag Equivalent1 ounces Inferred Mineral Resource: 2.41 million tonnes grading 262 g/t Ag and 2.11 g/t Au containing 30.4 million Ag Equivalent1 ounces. 1 Silver equivalency estimates were derived using metal prices of US$13.75/oz for silver and US$856.16/oz for gold (36-month average + 24 month future metal prices as of July 31, 2009). Metallurgical recoveries were estimated at 92.5% for silver and 91.5% for gold based on metallurgical testing completed by Metcon Research of Tucson, Arizona as of March 2009. The resource estimate incorporates data from 196 core drill holes totaling 64,204 meters and 908 underground channel samples. Previously reported NI 43-101 compliant resources for San Jose were estimated at 1.47 million tonnes grading 263 g/t Ag and 2.19 g/t Au in the Indicated category and 3.9 million tonnes grading 261 g/t Ag and 2.57 g/t Au in the Inferred category (see March 31, 2007 Technical Report available on the company website (www.fortunasilver.com) and on SEDAR). Approval of Environmental Impact Study On October 23rd, 2009, the “Secretaria de Medio Ambiente y Recursos Naturales” (Mexican Envi- ronmental Agency) delivered the approval of the Environmental Impact Study for full mine and mill construction and operation at the San Jose silver-gold project, located in the southern State of Oaxaca, Mexico. The October 23rd, 2009 government approval authorizes the construction and future operation of the San Jose Mine, including the underground workings, processing plant, tailings facility and other sur- face infrastructure for a 1,500 tonne per day operation within an area of ninety-two hectares. The permit contemplates a processing plant that will use conventional flotation for production of high grade silver- and gold- bearing concentrates, without the use of cyanide. The primary source of indus- trial water for the project will be from a gray-water treatment facility located thirteen kilometers from the mine site. Approval of Change of Land Use On December 14, 2009, the “Secretaria de Medio Ambiente y Recursos Naturales” (Mexican Envi- ronmental Agency) approved the Company’s application for a change of land use from agricultural to industrial for the San Jose silver-gold project, located in the southern State of Oaxaca, Mexico. This is the final permit required to commence construction activities and complements the Environ- mental Impact Study, which was approved in late October 2009. 5 3 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated Other permits On April 28, 2009, the “Comision Federal de Electricidad” (Mexican Federal Energy Commission) issued the permit to connect to the national power grid for up to five megawatts; sufficient power to cover the requirements of a 1,500 tonnes per day mine operation. The transformer sub-station site will be located within five hundred meters of the main high voltage power line which runs through the Company´s property. Project Engineering The Company has received from its consultants all the engineering design that form up the San Jose Pre-Feasibility Study which include the processing plant, tailings facility, power project, water project, surface infrastructure, mine design, and other matters. The Company´s engineering staff is currently conducting an internal review of the various engineering projects and continues to work towards the delivery of the final feasibility study by the first quarter of 2010. The Company has engaged North American engineering firm CAM to provide Qualified Person supervi- sion for the project engineering and to author required Technical Reports. Mexico - Tlacolula Silver Project The 12,000 ha Tlacolula property is located 14km E-SE of the city of Oaxaca, 20km north of the Taviche District, where high-grade silver has been mined since Spanish colonial times, and is 30km northeast of the Company’s 100% owned San Jose silver-gold development project. In September 2009, the Company, through its wholly owned subsidiary, Cuzcatlan, was granted an option (the “Option”) to acquire a 60% interest (the “Interest”) in the Tlacolula silver project (“prop- erty”) located in the State of Oaxaca, Mexico from Radius Gold Inc.’s wholly owned subsidiary, Radius (Cayman) Inc. (“Radius”) (a related party by way of directors in common with the Company). The Com- pany can earn the Interest by spending $2 million, which includes a commitment to drill 1,500 meters within three years, and making staged annual payments of $0.25 million cash and $0.25 million in common stock of the Company to Radius according to the following schedule: • $0.02 million cash and $0.02 million cash equivalent in shares upon stock exchange approval; • $0.03 million cash and $0.03 million cash equivalent in shares by the first year anniversary; • $0.05 million cash and $0.05 million cash equivalent in shares by the second year anniversary; • $0.05 million cash and $0.05 million cash equivalent in shares by the third year anniversary; and, • $0.10 million cash and $0.10 million cash equivalent in shares by the fourth year anniversary. Upon completion of the cash payments and share issuances, and incurring the exploration expenditures as set forth above, the Company will be deemed to have exercised the Option and acquired a 60% interest in the property, whereupon a joint venture will be formed to further develop the property on the basis of the Company owning 60% and Radius 40%. On January 15, 2010, the transaction was approved by the TSX Venture Exchange, The Company has issued 7,813 common shares of the Company at a fair market value of $2.56 per share and paid $0.02 million cash according to the terms of the option agreement. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated CASH COST PER SILVER OUNCE AND CASH COST PER TONNE (NON-GAAP MEASURES) Cash cost per ounce and cash cost per tonne are key performance measures that management uses to monitor performance. In addition, cash costs are presented as they represent an industry standard method of comparing certain costs on a per unit basis and management believes that certain investors use these non-GAAP measures to evaluate the Company’s performance. These performance measures have no meaning within Canadian Generally Accepted Accounting Principles (“Canadian GAAP”), and, therefore, amounts presented may not be comparable to similar data presented by other mining com- panies. The following table presents a reconciliation of cash costs per tonne of processed ore and cash cost per ounce of payable silver to the cost of sales in the consolidated statement of operations for the years ended December 31, 2009 and 2008. Cost of sales Add / (Subtract) Change in inventory (ore and concentrate stock piles) Depletion, depreciation, and accretion Cash cost $’000’s Years ended December 31, 2008 20,968 2009 23,699 442 (5,944) 18,197 (225) (5,363) 15,380 Total processed ore (tonnes) 395,561 331,380 Cash cost per tonne of processed ore ($/t) Cash cost Add / (Subtract) By-product credits 1 Refining charges Cash cost applicable per payable ounce 46.00 18,197 (27,318) 1,416 (7,705) 46.41 15,380 (18,879) 659 (2,840) Payable silver ounces 1,563,775 750,822 Cash cost per ounce of payable silver ($/oz) (4.93) (3.78) 1 By-product credits are included in the provisional liquidation LIQUIDITY AND CAPITAL RESOURCES The Company’s cash as at December 31, 2009 was $30.76 million (2008: $29.45 million) and $6.03 million (2008: $nil) in short term investments. During 2009, cash generated by operating activities before changes in working capital was $15.91 million. Further liquidity consumed by changes in working capital amounted to $2.22 million, for total cash generated by operating activities of $13.69 million. 7 3 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated During 2009, the Company invested a total amount of $11.02 million in mineral properties, $3.10 mil- lion in plant and equipment, and $5.99 million in short term investments. Additionally, the Company collected a net amount of value added tax refundable credit from the Mexican Government of $2.90 million. This is net of value added tax disbursements on local expenses during the period. As at December 31, 2009, the Company’s working capital amounted to $36.14 million compared to working capital of $34.06 million at December 31, 2008. On January 6, 2010, the Company signed a commitment letter to enter into a $20 million senior se- cured revolving credit facility with The Bank of Nova Scotia. The facility has a 2.5 year maturity. The proceeds of the facility may be used for general corporate purposes, including the development of the San Jose Project in Mexico. The facility is intended to complement Fortuna’s strong cash position and provide additional financing flexibility during the construction stage at San Jose. No funds have been drawn under this facility. On March 2, 2010 and the Company issued 15,007,500 common shares at a price of CAD$2.30 per shares, under the bought deal financing for gross proceeds of CAD$34.5 million. Net proceeds of CAD$32.8 million after underwriting fees of CAD$1.7 million were raised from the bought deal financing. Management believes the Company’s cash position as well as its ongoing operation in Caylloma is suf- ficient to support the Company’s operating and capital requirements on an ongoing basis. Actual fund- ing requirements may vary from those planned due to further acquisition opportunities. Management believes it will be able to raise equity capital or access debt facilities as required in both the short and long term, but recognizes the uncertainty attached thereto. GUARANTEES AND INDEMNIFICATIONS The Company may provide guarantees and indemnifications in conjunction with transactions in the normal course of operations. These are recorded as liabilities when reasonable estimates of the obliga- tions can be made. Indemnifications that the Company has provided include obligation to indemnify: • • directors and officers of the Company and its subsidiaries for potential liability while acting as a director or officer of the Company, together with various expenses associated with defending and settling such suits or actions due to association with the Company; certain vendors of acquired company for obligations that may or may not have been known at the date of the transaction. The Company acts as a guarantor to capital lease obligations held by two of its mining contractors. These capital lease contracts are related to the acquisition of mining equipment deployed at the Cayl- loma mine. OFF-BALANCE SHEET ARRANGEMENTS The Company does not have any off-balance sheet arrangements or commitments that are expected to have a current or future effect on our financial condition, results of operations, liquidity, capital expen- ditures, or capital resources that is material to investors, other than those disclosed in this MD&A and the consolidated financial statements and the related notes. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RELATED PARTY TRANSACTIONS (EXPRESSED IN $’000’S) The Company incurred charges from directors, officers, and companies having a common director or officer as follows: Expressed in $’000’s Years ended December 31, Transactions with related parties Consulting fees1 Salaries and wages2,3 other general and administrative expenses3 $ $ 2009 145 122 159 426 $ $ 2008 62 104 74 240 1 2 2,3 Consulting fees includes fees paid to two directors, Simon Ridgway and Mario Szotlender. Salaries and wages includes employees’ salaries and benefits charged to the Company based on an estimated percentage of the actual hours worked for the Company Radius Gold Inc. (“Radius”) has directors in common with the Company and shares office space, and is reimbursed for various general and administrative costs incurred on behalf of the Company. In September 2009, the Company was granted an option to acquire a 60% interest in the Tlacolula silver project located in the State of Oaxaca, Mexico from Radius. Refer to Notes to the Consolidated Financial Statements Note 10. c). Amounts due to/(from) related parties Owing (from)/to a director and officer4 Owing to a company with common directors3 Expressed in $’000’s December 31, 2009 (1) 50 49 $ $ $ December 31, 2008 - 38 38 $ $ $ 4 Owing from a director includes a non-interest bearing loan to Jorge A. Ganoza Durant with no specific terms of repayments. The transactions with related parties are measured at the agreed upon exchange amount, which is the amount of consideration established and agreed upon by the parties. The balances with related parties are unsecured, non-interest bearing, and payable in the normal course of business. CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the consolidated finan- cial statements and the reported amounts of revenue and expenses during the reporting periods. These estimates and assumptions are based on established industry standards, historical experience, and are reviewed on an ongoing basis to confirm their continued applicability. Depletion and Mineral Properties Cost Mineral property costs are comprised of acquisition costs and capitalized exploration, construction and development costs. Upon initiating production, the asset is depleted over its estimated useful life on a units-of-production basis. The Company estimates reserves and resources and the economic life of its mines and utilizes this information to calculate depletion expense. Depletion charges are adjusted prospectively based on periodic re-assessments of the Company’s mineral reserves. 9 3 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated The estimate of mineral reserves is prepared by Qualified Persons in accordance with industry stan- dards defined under NI 43-101 of the Canadian Securities regulatory authorities. Mineral reserve estimates can change over time as a result of numerous factors, including changes in metal prices, production costs, or the re-evaluation of geological, engineering and economic data of a deposit. A significant reduction in mineral reserves would have a negative impact on the calculation of the deple- tion of this asset. Asset Retirement Obligations Fortuna’s determination for asset retirement obligations involves estimation of timing and amounts of future costs relating to ongoing environmental and mine closure activities required under applicable law or the Company’s own remediation plans. These estimates are subject to significant uncertainties because many of these costs will not be incurred for a number of years, the nature of the reclamation activities might change and the assumptions regarding the rate of inflation and credit risk-adjusted interest rate used in the calculation may vary over time. Therefore, actual costs and their timing might differ from current estimates. Impairment of Long-lived Assets Management reviews and evaluates its long-lived assets for impairment when events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Examples of such events or circumstances are changes in metal prices, sudden physical deterioration of the asset, legal circumstances or political risks in the countries Fortuna operates, or other external factors which could have a significant impact on the operations of the Company. Impairment is considered to exist if total estimated future cash flows or probability-weighted cash flows on an undiscounted basis are less than the carrying amount of the assets, including mineral property, plant and equipment and non-producing property. An impairment loss is measured and recorded based on discounted estimated future cash flows or the application of an expected present value technique to estimate fair value in the absence of a market price. Future cash flows include recoverable proven and probable reserves and a portion of recoverable resources, silver, zinc, copper, lead and gold prices (considering current and historical prices, price trends and related factors), production levels, capital and reclamation costs, all based on detailed engineering life-of-mine plans. Assumptions underlying future cash flow estimates are subject to risks and uncertainties. Any differences between significant assumptions and market conditions and/or the Company’s performance could have a material effect on any impairment provision, and on the Company’s financial position and results of operations. Income Taxes The estimation of the Company’s future tax liabilities and assets involves significant judgment around a number of assumptions. Judgement must be used to determine the Company’s future earning poten- tial, and the expected timing of the reversal of future tax assets and liabilities. Further uncertainties are the result of interpretation of tax legislation in a number of jurisdictions which might differ from the ultimate assessment of the tax authorities. These differences may affect the final amount or the timing of the payment of taxes. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated CRITICAL ACCOUNTING ESTIMATES (continued) Stock-based Compensation The determination of the value of stock-based compensation is estimated using the Black-Scholes option pricing model. Option pricing models require the input of highly subjective assumptions, par- ticularly as to the expected price volatility of the stock. Other assumptions include the expected life of the options and the risk-free interest rate at the time of the grant. Changes in these assumptions can materially affect the fair value estimated. FINANCIAL INSTRUMENTS The carrying value of cash, accounts receivable, accounts payable and accrued liabilities, due to re- lated parties, net approximate their fair value due to the relatively short periods to maturity and the terms of these financial instruments. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve un- certainties and matters of significant judgement and, therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The Company enters into derivative contracts to manage its exposure to fluctuations in base metal prices. These contracts are marked-to-market at the end of each period, and the changes in estimated fair value are recorded as an unrealized gain (loss) on commodity contracts in the statement of opera- tions. As at December 31, 2009 the Company estimated the fair value of the outstanding contracts to constitute a liability of $3.06 million, and recorded a loss in the consolidated statements of operations for the year of $7.36 million. The estimated fair value was determined based on using applicable valu- ation techniques for commodity options with reference to the published market prices for underlying commodities quoted at the London Metal Exchange. The long term investments in marketable securities are classified as available-for-sale and are mea- sured at fair value at the end of each period. Fair value of these investments is determined based on published market prices of underlying securities. Change in fair values of available-for-sale marketable securities is recognized in other comprehensive income. At December 31, 2008 the Company had an investment in 3,706,250 shares of Continuum. These shares were de-recognized upon the Company’s acquisition of Continuum on March 6, 2009 and a loss of $0.46 million was recorded in the statement of operations to reflect the realization of the loss. The Company’s financial instruments are exposed to certain financial risks, including currency risk, credit risk, liquidity risk, interest risk, and metal price risk. (a) Fair value of financial instruments The Canadian Institute of Chartered Accountants (“CICA”) Handbook Section 3862 “Financial Instru- ments - Disclosure” requires disclosure of a three-level-hierarchy for fair value measurements based upon transparency of inputs to the valuation of financial instrument carried on the balance sheet at fair value. The three levels are defined as follows: • Level 1 - inputs to the valuation methodology are quoted (unadjusted) for identical assets or li- abilities in active markets. 1 4 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated • Level 2 - inputs to valuation methodology include quoted market prices for similar assets and li abilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. • Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value of measurement. The carrying value of cash, short term investments, accounts receivable, accounts payable and accrued liabilities, due to related parties, net, approximate their fair value due to the relatively short periods to maturity and the terms of these financial instruments. Fair value estimates are made a specific point in time, based on relevant market information and infor- mation about the financial instrument. These estimates are subjective in nature and involve uncertain- ties and matters of significant judgement and, therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The Company has classified the determination of fair value of accounts receivable, and derivatives as level 2, as the valuation method used by the Company includes an assessment of assets in quoted markets with significant observable inputs. Short term investments Accounts receivable Derivatives Expressed in ‘000’s Financial assets (liabilities) at fair value as at December 31, 2009 Level 1 6,034 - - 6,034 $ $ Level 2 - 8,322 (3,055) 5,267 $ $ $ $ Level 3 - - - - $ $ Total 6,034 8,322 (3,055) 11,301 1 Comparative information has not been presented in the table because this information is not required in the year of adoption. For periods subsequent to the year of adoption comparative information would be necessary. Accounts receivable includes accounts receivable from provisional sales. The fair value of accounts receivable resulting from provisional pricing reflect observable market commodity prices. Resulting fair value changes accounts receivable are through sales. Transactions involving accounts receivable are with counterparties the Company believes are creditworthy. Derivatives are carried at their fair value, which is determined based on internal valuation models that reflect observable forward market commodity prices. Resulting fair value changes to derivatives are through net gain(loss) on commodity contracts. Transactions involving derivatives are with counterpar- ties the Company believes to be creditworthy. (b) Currency risk The Company is exposed to the financial risk related to the fluctuation of foreign exchange rates. The Company operates in Canada, Peru, Mexico, and Barbados and a portion of its expenses are incurred in Canadian dollars, Nuevo Soles, and Mexican Pesos. A significant change in the currency exchange rates between the United States dollar relative to the other currencies could have a material effect on the Company’s results of operations, financial position or cash flows. The Company has not hedged its exposure to currency fluctuations. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated FINANCIAL INSTRUMENTS (continued) At December 31, 2009, the Company is exposed to currency risk through the following assets and li- abilities denominated in Canadian dollars, Nuevo Soles and Mexican Pesos (all amounts are expressed in thousands of Canadian dollars, thousands of Nuevo Soles or thousands of Mexican Pesos): Expressed in ‘000’s Cash Short term investments Accounts receivable Accounts payable and accrued liabilities Canadian Dollars 21,283 S/. 560 5 $ December 31, 2009 Nuevo Soles Mexican Pesos 1,283 - 6,565 302 $ - 880 December 31, 2008 Canadian Dollars $ 29,748 - 13 S/. Nuevo Soles 629 $ - 10,400 Mexican Pesos 3,864 - 46,460 (194) (17,150) (623) (172) (5,281) (10,259) Based on the above net exposure as at December 31, 2009, and assuming that all other variables remain constant, a 10% depreciation or appreciation of the US dollar against the above currencies would result in an increase or decrease expressed in US dollars, as follows: Impact to other comprehensive income (loss) Impact to net income (loss) (614) $ 2,293 $ 65 $ (c) Credit risk Credit risk is the risk of an unexpected loss if a customer or third party to a financial instrument fails to meet its contractual obligations. The Company’s cash equivalents and short term investments are held through large Canadian, international and foreign national financial institutions. These investments mature at various dates within one year. All of the Company’s trade accounts receivables are held with large international metals trading companies. The Company holds derivative contracts with financial institutions and in this regard is exposed to counterparty risk. The Company mitigates this risk by transacting only with reputable financial institu- tions to minimize credit risk. As at December 31, 2009, the Company has a Mexican value added tax of $0.42 million and Peruvian value added tax of $0.18 million. The Company expects to recover the full amounts from the Mexican and Peruvian Governments. (d) Liquidity risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they fall due. The Company manages liquidity risk by continuing to monitor forecasted and actual cash flows. The Company has in place a planning and budgeting process to help determine the funds required to support the Company’s normal operating requirements on an ongoing basis and its development plans. The Company strives to maintain sufficient liquidity to meet its short term business requirements, taking into account its anticipated cash flows from operations, its holdings of cash, short term invest- ments, and its committed liabilities. 3 4 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated The Company expects the following maturities of its financial liabilities (including interest), operating lease and other contractual commitments: Accounts payable and accrued liabilities Due to related parties, net Derivatives Long term liability Total1 Expressed in ‘000’s Expected payments due by period as at December 31, 2009 Less than 1 year 8,083 $ 49 3,055 1,038 12,225 $ 1-3 years - - - 1,454 1,454 $ $ 4-5 years - $ - - - - $ $ $ After 5 years - $ - - - - $ Total 8,083 49 3,055 2,492 13,679 1 Amounts above do not include payments related to the following: (i) the Company’s anticipated asset retirement obligation of $2,529 associated with mine closure, land reclamation, and other environmental matters. (e) Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The risk that the Company will realize a loss as a result of a decline in the fair value is limited because the balances are generally held with major financial institutions in demand deposit accounts. (f) Metal price risk The Company is exposed to metals price risk with respect to silver, gold, zinc, and lead sold through its mineral concentrate products. The Company mitigates this risk by implementing price protection programs for some of its zinc and lead production through the use of derivative instruments. As a mat- ter of policy, the Company does not hedge its silver production. OTHER DATA Additional information related to the Company is available for viewing at www.sedar.com and the Com- pany’s website at www.fortunasilver.com. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated SHARE POSITION AND OUTSTANDING WARRANTS AND OPTIONS The Company’s outstanding share position at March 11, 2010 is 110,062,465 common shares. In ad- dition, a total of 8,150,500 incentive stock options, with 2,665,000 subject to shareholder approval, are currently outstanding as follows: Type of Security No. of Shares Incentive Stock Options: TOTAL OUTSTANDING OPTIONS: 30,000 270,000 250,000 60,000 200,000 7,500 225,000 860,000 225,000 95,000 700,000 50,000 15,000 5,000 38,000 30,000 25,000 250,000 150,000 1,100,000 650,000 250,000 2,150,000 490,000 25,000 8,150,500 Exercise Price CAD$ $0.80 $1.35 $2.29 $1.75 $1.75 $0.85 $1.55 $1.66 $1.61 $0.85 $2.22 $2.75 $0.85 $0.85 $0.85 $0.85 $0.85 $2.52 $1.25 $0.85 $0.85 $0.83 $1.60 $1.70 $2.23 Expiry Date July 24, 2010 February 5, 2016 March 30, 2016 May 8, 2016 May 22, 2016 July 5, 2016 July 5, 2016 July 10, 2016 September 13, 2016 January 11, 2017 January 11, 2017 February 6, 2017 April 22, 2017 May 31, 2017 June 27, 2017 July 2, 2017 October 24, 2017 February 5, 2018 August 25, 2018 October 5, 2018 November 5, 2018 July 6, 2019 October 27, 2019 November 8, 2019 November 23, 2019 CHANGE IN ACCOUNTING POLICY Change in Reporting Currency Effective January 1, 2009, the Company changed its reporting currency to the US dollar. The change in reporting currency is to better reflect the Company’s business activities and to improve investors’ ability to compare the Company’s financial results with other publicly traded businesses in the mining industry. Prior to January 1, 2009, the Company reported its annual and quarterly consolidated bal- ance sheets and the related consolidated statements of operations and cash flows in Canadian dollar (CAD). 5 4 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated In making this change in reporting currency, the Company followed the recommendations of the Emerg- ing Issues Committee (EIC) of the Canadian Institute of Chartered Accountants (“CICA”), set out in EIC-130, “Translation Method when the Reporting Currency Differs from the Measurement Currency or there is a Change in the Reporting Currency”. In accordance with EIC-130, the financial statements for all years and periods presented have been translated in to the new reporting currency using the cur- rent rate method. Under this method, the statements of operations and cash flows statements items for each year and period have been translated into the reporting currency using the average exchange rates prevailing during each reporting period. All assets and liabilities have been translated using the exchange rate prevailing at the consolidated balance sheets dates. All resulting exchange differences arising from the translation are included as a separate component of other comprehensive income. All comparative financial information has been restated to reflect the Company’s results as if they had been historically reported in US dollars. Adoption of New Accounting Standards Goodwill and Intangible Assets (Section 3064) In February 2008, the CICA issued the following Handbook Sections : Section 3064, “Goodwill and In- tangible Assets”, which replaces Section 3062, “Goodwill and Intangible Assets”, and Section 3450, “Research and Development Costs”, and amended Section 1000, “Financial Statement Concepts”. The standard intends to reduce the differences with International Financial Reporting Standards (“IFRS”) in the accounting for intangible assets and results in closer alignment with U.S. GAAP. Un- der previous Canadian standards, more items are recognized as assets than under IFRS or U.S. GAAP. The objectives of Section 3064 are to reinforce the principle-based approach to the recognition of as- sets only in accordance with the definition of an asset and the criteria for asset recognition; and clarify the application of the concept of matching revenues and expenses such that the current practice of recognizing assets that do not meet the definition and recognition criteria are eliminated. The standard also provides guidance for the recognition of internally developed intangible assets (including research and development activities), ensuring consistent treatment of all intangible assets, whether separately acquired or internally developed. This standard is effective for fiscal years beginning on or after Oc- tober 1, 2008. The Company has evaluated the new section and determined that adoption of these new requirements did not have a material impact on the Company’s consolidated financial statements. Credit risk and fair value of financial assets and financial liabilities In January 2009, the Emerging Issues Committee of the CICA issued EIC-173 “Credit Risk and the Fair Value of Financial Assets and Financial Liabilities”. This guidance clarified that an entity’s own credit risk and the credit risk of the counterparty should be taken into account in determining the fair value of financial assets and financial liabilities including derivative instruments, for presentation and disclosure purposes. The guidance is to be applied retrospectively without restatement of prior periods to all financial assets and liabilities measured at fair value in interim and annual financial statements for periods ending on or after the date of issuance of this Abstract. Retrospective application with restatement of prior periods is permitted but not required. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated The Company has evaluated the new section and determined that adoption of these new requirements did not have a material impact on the Company’s consolidated financial statements. Mining Exploration Costs On March 27, 2009, the Emerging Issues Committee of the CICA issued EIC-174 “Mining Exploration Costs” which applies to interim and annual financial statements for periods ending on or after January 20, 2009. This guidance clarified that an entity that has initially capitalized exploration costs has an obligation in the current and subsequent accounting periods to test such costs for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The Company has adopted this new standard in its December 31, 2009 annual financial statements with no impact on the Company’s consolidated financial statements. Foreign currency translation Fortuna Silver Mines Inc.’s functional currency is the Canadian dollar. Effective January 1, 2009, the Company changed its reporting currency to the US dollar. All subsidiaries, except its wholly owned subsidiary, Minera Bateas S.A.C. (“Bateas”), are considered to be self sustaining operations. Bateas’s integrated foreign operations and their financial statements are translated to US dollars under the temporal method. Monetary assets and liabilities denominated in foreign currencies are translated at the exchange rate in effect at the balance sheet date and non- monetary assets and liabilities at historical exchange rates. Revenues and expenses are translated at the average exchange rate in effect during the period. Realized and unrealized foreign exchange gains and losses are included in earnings. Commencing January 1, 2009, Bateas is an integrated foreign operation because Bateas translates its financial statements denominated in Peruvian Soles to US dollars using the temporal method. All other subsidiaries’ financial statements are translated using the current rate method. Assets and are translated into US dollars using the current rate method at period-end exchange rates and resulting translation adjustments are reflected in comprehensive income. Revenues and expenses are translated at average exchange rates for the period. The Company has assessed new and revised accounting pronouncements that have been issued and determined that the following may have an impact on the Company: Convergence with International Financial Reporting Standards (“IFRS”) In 2006, the Canadian Accounting Standards Board (“AcSB”) published a new strategic plan that will significantly affect financial reporting requirements for Canadian companies. The AcSB strategic plan outlines the convergence of Canadian GAAP with International Financial Reporting Standards (“IFRS”) over an expected five year transitional period. In February 2008, the AcSB announced that 2011 is the changeover date for publicly-listed companies to use IFRS, replacing Canadian GAAP. This date is for interim and annual financial statements relating to fiscal years beginning on or after January 1, 2011. The Company will begin reporting its financial statements in accordance with IFRS on January 1, 2011, with comparative figures for 2010. CHANGE IN ACCOUNTING POLICY (continued) RECENT RELEASED CANADIAN ACCOUNTING STANDARDS 7 4 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated The adoption date of January 1, 2011 will require the restatement, for comparative purposes, of amounts reported by the Company for its year ended December 31, 2010, and of the opening balance sheet as at January 1, 2010. During 2009, the Company began planning its transition to IFRS. The process will consist of three phases: Scoping and Diagnostics, Analysis and Development, and Implementation and Review. During the third quarter of 2009, the Company, with the assistance of external advisors, completed an initial scoping and diagnostic assessment. This assessment identified, at a high level, the key areas for more detailed consideration and that may give rise to potential difference upon conversion. As part of this phase, preliminary recommendations were made in respect of transitional elections available under IFRS 1, “First-Time Adoption of International Reporting Standards”. At the present time the Company is planning to apply two of the 17 exemptions which include: • IFRS 3 “Business Combinations” which allows an entity that has conducted prior business combinations to apply IFRS 3 on a prospective basis only from the date of transition. This avoids the requirement to restate prior business combinations, although some adjustments may still be necessary. Currently, the Company has three prior business transactions that meet the criteria of a business combination under IFRS. • IFRS 2 “Share-Based Payment Transactions” which allows full retrospective application to be avoided for certain share-based instruments depending on the grant date, vesting terms and settlement of any related liabilities. The Company has not disclosed the value of the share options historically and therefore cannot apply IFRS 2 retrospectively. Following the completion of the scoping and diagnostic assessment, the Company engaged external advisors to assist with detailed technical reviews of the identified potential high impact areas. These reviews include the identification of IFRS - Canadian GAAP differences, accounting policy consider- ations, and preliminary implementation plans. The high impact areas relating to conversion include foreign currency; property, plant and equipment; income taxes; and provisions (including asset retire- ment obligations). The technical review aspects of these assessments have been completed for foreign currency; property, plant and equipment; and income taxes. A summary of the potential impacts in these areas are as follows: a) Foreign Currency Under International Accounting Standard (“IAS”) 21, it is necessary to assess the functional currency of all the Company’s entities based on the primary economic environment in which the entity operates. In addition, secondary factors may also provide evidence of an entity’s functional currency. Once the functional currency is determined, it does not change unless there is a change in the underlying nature of the transactions and relevant conditions and events. All entities that have a Canadian GAAP measurement currency that is different than the functional cur- rency under IFRS will need to translate their balance sheets to the functional currency at the transition date. The Company will need to update its consolidation model for foreign currency translation. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RECENT RELEASED CANADIAN ACCOUNTING STANDARDS (continued) The Company’s preliminary analysis is the functional currency of all the group’s entities is U.S. dollars, the same as the presentation currency. As a result, the Company is planning to take the IFRS 1 exemp- tion that resets the cumulative translation adjustment balance to zero, to reduce the conversion effort. b) Property, Plant and Equipment Under IAS 16, each part of an item of property, plant and equipment with a cost that is significant in relation to the total costs of an item is depreciated separately. This is commonly referred to as com- ponent depreciation. Each separate part is depreciated over its useful economic life to the residual value. Under IFRS, the assessment of the useful economic life and the residual value of each part of the asset are determined on an annual basis. The Company is currently completing a detailed review of fixed assets to determine if additional component depreciation will be necessary. Canadian GAAP does not specifically state how to treat borrowing costs related to the construction of an asset, whereas IFRS states that borrowing costs that are directly attributable to the acquisition or construction of a qualifying asset shall be capitalized as part of the cost of that asset on a net basis. Under IFRS, there is an option to use either the cost method or the revaluation model for subsequent measurement of classes of assets. The Company plans to continue to use the cost method. For impairment, Canadian GAAP generally uses a two-step approach to testing: first comparing asset carrying values with undiscounted future cash flows to determine whether impairment exists, and then measuring any impairment by comparing asset carrying values with fair values. IAS 36, “Impairment of Assets”, uses a one-step approach for both testing for and measurement of impairment, with carrying values compared directly with the higher of fair value less costs to sell and value in use (which uses discounted future cash flows). This may potentially result in more write downs when carrying values of assets are supported under Canadian GAAP on an undiscounted cash flow basis, but could not be supported on a discounted cash flow basis. However, the extent of any new writedowns may be partially offset by the requirement under IAS 36 to reverse any previous impairment losses where circumstances have changed such that the impairments have been reduced. Canadian GAAP prohibits reversal of impairment losses. c) Income Taxes The analysis completed to date has identified two significant relevant differences in the area of ac- counting for income taxes. Canadian GAAP has a specific exemption for future income taxes related to non-monetary assets or liabilities of integrated foreign operations. Future income taxes cannot be recognized for a temporary difference arising from the difference between the historical exchange rate and the current exchange rate translation of the cost of non-monetary assets or liabilities of integrated foreign operations. Under IFRS, deferred tax is recognized on the difference between: the accounting basis of all items, which is accounted for as specified under IFRS. For foreign currency non-monetary assets or liabilities, this is the local or tax basis currency translated into the functional currency at the historical rate; and the tax 9 4 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated basis, which is the local or tax basis currency amount translated to the functional currency at the spot exchange rate at the balance sheet date. The result of this calculation difference will be added volatil- ity in the tax expense as foreign exchange swings will have an impact on the tax expense. IFRS 12 does not permit recognition of a temporary difference on initial recognition, except if the transaction is a business combination or if the transaction affects accounting or taxable profit or loss. Under Canadian GAAP, assets acquired in other than in a business combination, may have a tax basis different than the carrying amount on acquisition. The associated FIT assets (subject to the more likely than not test) or liability is recognized at the time of acquisition and added to the cost of the asset. The amount of the FIT is calculated using a simultaneous equation; this method of tax calculation is referred to as the ‘gross up’ method. Under IAS 12, any temporary differences arising on subsequent asset acquisitions, other than in a business combination, would be ignored. On adoption of IFRS, the temporary differences arising from the ‘gross up’ method under Canadian GAAP will be reversed. Following the completion of the 2009 year-end filings, the Company will commence quantification of the identified technical differences. Concurrent with the technical analysis, we have prepared draft pro forma consolidated annual IFRS financial statements to help understand the disclosure impact of the change to IFRS. These will be presented to the Audit Committee at the end of the first quarter of 2010. The Company will continue to monitor changes in IFRS leading up to the changeover date, and will update the conversion plan as required. Business Combinations In January 2009, the CICA issued the following Handbook Sections: Section 1582, “Business Com- binations”, Section 1601, “Consolidated Financial Statements”, and Section 1602, “Non-controlling Interests”. These new standards are harmonized with International Financial Reporting Standards (IFRS). Section 1582 specifies a number of changes, including: an expanded definition of a busi- ness, a requirement to measure all business acquisitions at fair value, a requirement to measure non- controlling interests at fair value, and a requirement to recognize acquisition-related costs as expenses. Section 1601 establishes the standards for preparing consolidated financial statements. Section 1602 specifies that non-controlling interests be treated as a separate component of equity, not as a liability or other item outside of equity. The new standards will become effective in 2011 but early adoption is permitted. The Company is evaluating the attributes of early adoption of this standard and its potential effects if events or transactions occurred that this standard applies to. Comprehensive revaluation of Assets and Liabilities and Equity In August 2009, the CICA amended Section 1625, “Comprehensive revaluation of assets and liabili- ties” as a result of issuing “Business Combinations, Section 1582, “Consolidated Financial State- ments”, Section 1601, and Non-Controlling Interests”, Section 1602, in January 2009. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RECENT RELEASED CANADIAN ACCOUNTING STANDARDS (continued) In August 2009, the CICA amended Section 3251, “Equity” as a result of issuing Section 1602, “Non- controlling Interests”. These amendments only apply to entities that have adopted Section 1602. These amendments apply prospectively to comprehensive revaluations of assets and liabilities occur- ring in fiscal years beginning on or after January 1, 2011, but early adoption is permitted. The Com- pany is evaluating the attributes of early adoption of this standard and its potential effects if events or transactions occurred that this standard applies to. Financial Instruments and Impaired Loans In August 2009, the CICA issued amendments to Section 3855, “Financial Instruments: Recognition and Measurement”. These amendments will permit (or require in certain circumstances) entities to reclassify certain investments in debt instruments, will amend the guidance regarding impairment measurement for Held-to- Maturity debt instruments and will require reversals of impairment losses for Available for Sale debt instruments when conditions have changed. These amendments apply only to investments in debt instruments and do not apply to investments in equity investments or to debt instruments that have been designated at orgination as Held-for-Trading. In August 2009, the CICA amended Section 3025, “Impaired loans” to conform with the definition of a loan to that in amended Section 3855 and to include held-to-maturity investments within the scope of this Section. These amendments are effective for annual financial statements relating to fiscal years beginning on or after November 1, 2008 with early adoption permitted for interim financial statements issued on or after August 20, 2009. The Company has evaluated the new section and determined that adoption of these new requirements, for fiscal year end December 31, 2009, did not have a material impact on the Company’s consolidated financial statements. Metal price risk One of the most significant risks affecting the profitability and viability of the Company’s mining opera- tions is the fluctuation of metal prices. Volatility of metal prices is high by historic measures and strong downturns on these prices can have significant adverse effects on the continuity of the Company’s op- erations. In order to mitigate this risk in the medium term, the Company put in place price protection strategies for approximately 59% and 60% of its zinc and lead metal production, respectively, for the six month period between January 2010 and June 2010. For the six month period between July 2010 and December 31, 2010, the Company put in place price protection strategies for 59% and 57% of its zinc and lead metal production, respectively. Credit risk Credit risk is the risk of an unexpected loss if a customer or third party to a financial instrument fails to meet its contractual obligations. The Company’s cash equivalents and short term investments are held through large Canadian and international financial institutions. These investments mature at various dates within one year. RISKS AND UNCERTAINTIES 1 5 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Dollar amounts expressed in US dollars, unless otherwise indicated The Company is subject to credit risk through its trade receivables. The Company enters into one year contracts to sell its concentrate products at Caylloma and transacts only with credit worthy costumers to minimize credit risk. The Company awarded its full production of 2009 to large international metals trading companies, including Glencore International. The Company holds derivative contracts with financial institutions and in this regard is exposed to counterparty risk. The Company mitigates this risk by transacting only with reputable financial institu- tions to minimize credit risk. During 2009, the Company has transacted with Standard Bank PLC, Banco Bilbao Vizcaya Argentaria, S.A., Macquarie Bank Limited, Goldman Sachs, and Scotia Bank. The Company currently holds derivatives contracts with Macquarie Bank Limited and Scotia Bank. Environmental risk The Company has recorded an asset retirement obligation of $2.53 million as of December 31, 2009 in relation to the cost of reclamation associated with the Caylloma property. This amount has been estimated by a third party in compliance of local regulations and has been approved by the relevant authorities in November 2009. In view of the uncertainties concerning environmental reclamation, the ultimate cost of reclamation activities could differ materially from the estimated amount recorded. The estimate of the Company’s asset retirement obligation relating to the Caylloma mine is subject to change based on amendments to laws and regulations and as new information regarding the Company’s operations becomes available. Currency risk The Company is exposed to the financial risk related to the fluctuation of foreign exchange rates. The Company operates in Canada, Peru, Mexico, and Barbados and a portion of its expenses are incurred in Canadian dollars, Nuevo Soles, and Mexican Pesos. A significant change in the currency exchange rates between the United States dollar relative to the other currencies could have a material effect on the Company’s results of operations, financial position or cash flows. The Company has not hedged its exposure to currency fluctuations. Exploration and development The business of mineral exploration and extraction involves a high degree of risk. Few properties that are in the exploration stage ultimately become producing mines. Major expenses may be required to establish reserves by drilling and to construct mining and processing facilities at a site. It is impossible to ensure that exploration and development programs carried out by the Company will result in profit- able commercial mining operations. Resources and reserves There is a degree of uncertainty attributable to the estimation of resources and reserves and to expected mineral grades. Mineral Resources and Mineral Reserves may require revision based on actual produc- tion experience. Market fluctuations in the price of metals, as well as increased production costs and reduced recovery rates, may render certain mineral reserves uneconomic and may ultimately result in a restatement of resources and/or reserves. Short term operating factors relating to the mineral resources FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2009 Dollar amounts expressed in US dollars, unless otherwise indicated RISKS AND UNCERTAINTIES (continued) and reserves, such as the need for sequential development of ore bodies may adversely affect the Com- pany’s profitability in any accounting period. Political and country risk The Company’s mineral properties are located in emerging nations and consequently may be subject to a higher level of risk compared to developed countries. Operations, the status of mineral property rights, title to the properties and the recoverability of amounts shown for mineral properties in emerging nations can be affected by changing economic, regulatory, and political situations. The State of Oaxaca has a history of social conflicts and political agitation which can lead to public demonstrations and blockades that can from time to time affect the Company’s operations. CONTROLS AND PROCEDURES Disclosure Controls and Procedures The Company evaluated the effectiveness of the design and operation of the disclosure controls and procedures, as of December 31, 2009, under the supervision of the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”). Based on the results of this evaluation the CEO and the CFO have concluded that such disclosure controls are sufficiently effective to provide reasonable assurance that material information relating to the Company is made known to management and disclosed in ac- cordance with the applicable securities laws. Internal Control Over Financial Reporting The Company’s management, with the participation of its CEO and CFO, are responsible for establish- ing a system of internal control over financial reporting to provide reasonable assurance regarding the reliability and integrity of the Company’s financial information and the preparation of its financial state- ments in accordance with Canadian generally accepted accounting principles. Management of the Company, with the participation of the CEO and CFO, has evaluated the effectiveness of internal control over financial reporting as of December 31, 2009 and has concluded there are no material weaknesses. Management continues to review and refine its internal controls and procedures. MANAGEMENT CHANGES There were no management changes during the year ended December 31, 2009. OUTLOOK For 2010, the Company expects to sustain silver production at 1,700,000 ounces, with base metal production also remaining level at current rates. 2010 Production Guidance (rounded to whole thousands) Metal production Silver (oz) Zinc (lbs) Lead (lbs) Copper (lbs) 2010 (Forecast) 1,700,000 28,400,000 25,200,000 1,000,000 2009 (Actual) 1,683,000 28,442,000 25,137,000 88,000 2008 (Actual) 805,000 23,283,000 16,502,000 - 2007 (Actual) 480,000 13,900,000 8,300,000 - 3 5 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F Deloitte & Touche LLP 2800 - 1055 Dunsmuir Street 4 Bentall Centre P.O. Box 49279 Vancouver BC V7X 1P4 Canada Tel: 604-669-4466 Fax: 604-685-0395 www.deloitte.ca AUDITORS’ REPORT TO THE SHAREHOLDERS OF FORTUNA SILVER MINES INC. To the Shareholders of Fortuna Silver Mines Inc. We have audited the consolidated balance sheets of Fortuna Silver Mines Inc. as at December 31, 2009 and 2008 and the consolidated statements of operations, comprehensive income (loss), cash flows, and shareholders’ equity for the years then ended. These financial statements are the respon- sibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2009 and 2008 and the results of its opera- tions and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants March 18, 2010 CONSOLIDATED BALANCE SHEETS FORTUNA SILVER MINES INC. CONSOLIDATED BALANCE SHEETS AS AT DECEMBER 31, Expressed in thousands of US Dollars ASSETS CURRENT Cash Short term investments Derivatives Accounts receivable and prepaid expenses GST and value added tax Inventories LONG TERM INVESTMENT AND RECEIVABLE PROPERTY, PLANT AND EQUIPMENT MINERAL PROPERTIES LIABILITIES CURRENT Accounts payable and accrued liabilities Due to related parties, net Derivatives Current portion of long term liability LONG TERM LIABILITY ASSET RETIREMENT OBLIGATION FUTURE INCOME TAX LIABILITY NON-CONTROLLING INTEREST SHAREHOLDERS’ EQUITY SHARE CAPITAL CONTRIBUTED SURPLUS DEFICIT ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Notes 2009 4 5 6 7 8 9 10 11 12 5 13 a), 13 b) 13 a), 13 b) 14 15 3 $ $ $ 30,763 6,034 - 8,635 601 2,329 48,362 16 17,233 74,127 139,738 8,083 49 3,055 1,038 12,225 1,454 2,529 10,973 - 27,181 $ $ $ 2008 29,454 - 1,418 1,865 5,127 1,727 39,591 3,207 13,285 59,285 115,368 4,735 38 - 762 5,535 1,382 1,066 9,410 9,007 26,400 104,701 14,315 (9,357) 2,898 (6,459) 112,557 $ 139,738 98,206 11,854 (9,980) (11,112) (21,092) 88,968 $ 115,368 Commitments and contingencies Subsequent events 18 10, 22 APPROVED BY THE DIRECTORS: Jorge Ganoza Durant Simon Ridgway Director Director The accompanying notes are an integral part of these audited consolidated financial statements. 5 5 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F CONSOLIDATED STATEMENTS OF OPERATIONS FORTUNA SILVER MINES INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, Expressed in thousands of US Dollars, except for share and per share amounts Sales Cost of sales Depletion, depreciation and accretion MINE OPERATING INCOME Selling, general and administrative expenses (includes depreciation of $64 (2008: $49)) Stock-based compensation Write-off of deferred exploration costs OPERATING INCOME (LOSS) Interest and other income and expenses Interest and finance expenses Net (loss) gain on commodity contracts (Loss) on disposal of property, plant and equipment (Loss) on disposal of investment Foreign exchange (loss) gain INCOME BEFORE INCOME TAXES AND NON-CONTROLLING INTEREST Income tax provision Non-controlling interest NET INCOME (LOSS) FOR THE YEAR Earnings (Loss) per Share - Basic and Diluted Weighted average number of shares outstanding - Basic and Diluted Notes $ 12 16 d) $ $ 2009 51,428 17,755 5,944 27,729 9,558 2,707 1,081 13,346 14,383 433 (160) (7,356) (101) (236) (651) (8,071) 6,312 5,869 (180) 623 0.01 2008 $ 24,867 15,605 5,363 3,899 7,815 1,348 329 9,492 (5,593) 1,361 (98) 4,269 (45) - 793 6,280 687 1,699 (102) $ (910) $ (0.01) 91,802,881 84,400,969 The accompanying notes are an integral part of these audited consolidated financial statements. FORTUNA SILVER MINES INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, Expressed in thousands of US Dollars CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) Net income (loss) for the year Other comprehensive income (loss) Unrealized gain (loss) on available for sale long term investments, net of taxes Transfer of unrealized loss to realized loss upon derecognition of available for sale long term investment, net of taxes Unrealized gain on translation of functional currency to reporting currency Other comprehensive income (loss) Comprehensive income (loss) 148 462 13,400 14,010 14,633 $ $ 2009 623 $ 2008 (910) (745) - (21,754) (22,499) (23,409) $ The accompanying notes are an integral part of these audited consolidated financial statements. 7 5 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F CONSOLIDATED STATEMENTS OF CASH FLOWS FORTUNA SILVER MINES INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, Expressed in thousands of US Dollars OPERATING ACTIVITIES Net income (loss) for the year Items not involving cash Depletion and depreciation Accretion expense Future income tax Stock-based compensation Unrealized loss on commodity contracts Non-controlling interest Write-off of deferred exploration costs Loss on disposal of equipment Loss on disposal of investments Unrealized foreign exchange loss Changes in non-cash working capital items Accounts receivable and prepaid expenses Inventories Accounts payable Due to related parties Net cash provided by operating activities 3 INVESTING ACTIVITIES Costs relating to the acquisition of Continuum Acquisition of short term investments Mineral property expenditures Value added taxes on purchase of property, plant and equipment Property, plant & equipment Long term receivable Proceeds on disposal of equipment Acquisition of long term investments Proceeds on disposal of long term investments Net cash (used in) investing activities FINANCING ACTIVITIES Net proceeds on issuance of common shares Capital lease obligations Net cash provided by financing activities Effect of exchange rate changes on cash (DECREASE) IN CASH Cash - beginning of year Notes 2009 2008 $ 623 $ (910) 5,858 150 794 2,707 4,473 (180) 1,081 101 236 67 15,910 (5,073) (313) 3,158 4 13,686 (162) (5,990) (11,023) 2,897 (3,098) 96 47 (235) 489 (16,979) 1,025 (976) 49 4,553 (3,244) 29,454 5,350 102 1,698 1,348 8 (102) 329 45 - 785 8,653 255 (411) (172) 31 8,356 - - (21,200) (1,473) (3,535) (16) 37 - - (26,187) 7,586 (351) 7,235 (8,106) (10,596) 48,156 CASH - END OF YEAR Supplemental cash flow information 21 $ 30,763 $ 29,454 The accompanying notes are an integral part of these audited consolidated financial statements. FORTUNA SILVER MINES INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 Expressed in thousands of US Dollars, except for share amounts Share Capital Shares 80,977,663 $ Amount 90,176 $ Contributed Surplus (Deficit) 10,533 $ (9,070) Accumulated Other Comprehensive (Loss)Income 135 $ Total Shareholders’ Equity 91,774 $ Balance -December 31, 2007 Effect of change in reporting currency Exercise of options Exercise of warrants Transfer of contributed surplus on exercise of options Stock-based compensation (Loss) for the year Unrealized loss of available for sale long term investments Unrealized (loss) on translation of functional currency to reporting currency Balance - December 31, 2008 Exercise of options Exercise of warrants Issuance of shares for property Cancellation of fractional shares Transfer of contributed surplus on exercise of options Stock-based compensation Income for the year Unrealized gain on available for sale long term investments Transfer of unrealized loss to realized loss upon derecognition of available for sale long-term investment Unrealized gain on translation of functional currency to reporting currency Balance - December 31, 2009 - 31,400 4,322,596 85,331,659 $ 389,000 2,475,355 6,786,674 (36) - - - - - - - - - - - - 37 7,966 - - - 27 - - - (27) 1,348 - - - - - - - (910) 11,252 - - - - - - (745) 11,252 37 7,966 - 1,348 (910) (745) - 98,206 $ 281 776 5,192 - - - 11,854 $ (9,980) - - - - - - - - $ $ (21,754) (11,112) - - - - (21,754) 88,968 281 776 5,192 - 246 - - (246) 2,707 - - - 623 - - - - - 148 462 - 2,707 623 148 462 - - - - - 94,982,652 $ 104,701 $ - - 14,315 $ (9,357) $ 13,400 2,898 $ 13,400 112,557 The accompanying notes are an integral part of these audited consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY 9 5 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 01. NATURE OF OPERATIONS Fortuna Silver Mines Inc. (the “Company”) is engaged in silver mining and related activities, including exploration, extraction, and processing. The Company operates the Caylloma zinc/lead/silver mine in southern Peru and is currently developing the San Jose silver/gold project in Mexico. 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES a) Basis of presentation and principles of consolidation These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”), and presented in US dollars. The consolidated financial statements include the accounts of the Company and wholly owned subsidiaries: Minera Bateas S.A.C. (“Bateas”); Fortuna Silver (Barbados) Inc.; Compania Minera Cuzcatlan SA (“Cuzcatlan”); Continuum Resources Ltd. (“Continuum”); and Fortuna Silver Mines Peru S.A.C. All significant inter-company transactions and accounts have been eliminated upon consolidation. b) Change in Reporting Currency Effective January 1, 2009, the Company changed its reporting currency to the US dollar. The change in reporting currency better reflects the Company’s business activities and improves investors’ ability to compare the Company’s financial results with other publicly traded businesses in the mining industry. Prior to January 1, 2009, the Company reported its annual and quarterly consolidated balance sheets and the related consolidated statements of operations and cash flows in Canadian dollars (CAD). In making this change in reporting currency, the Company followed the recommendations of the Emerging Issues Committee (EIC) of the Canadian Institute of Chartered Accountants (“CICA”), set out in EIC-130, “Translation Method when the Reporting Currency Differs from the Measurement Currency or there is a Change in the Reporting Currency”. In accordance with EIC-130, the financial statements for all years and periods presented have been translated into the new reporting currency using the current rate method. Under this method, the statements of operations and cash flows statements items for each year and period have been translated into the reporting currency using the average exchange rates prevailing during each reporting period. All assets and liabilities have been translated using the exchange rate prevailing at the consolidated balance sheets dates. All resulting exchange differences arising from the translation are included as a separate component of other comprehensive income. All comparative financial information has been restated to reflect the Company’s results as if they had been historically reported in US dollars. $ Current Assets Total Assets Current Liabilities Total Liabilities Shareholders’ Equity Total Liabilities and Shareholders’ Equity expressed in CAD 000’S 48,413 141,072 6,769 32,282 108,790 141,072 Condensed Consolidated Balance Sheet As at December 31, 2008 expressed in USD 000’S 39,591 115,368 5,535 26,400 88,968 115,368 foreign currency translation at 1.22267 (8,822) (25,704) (1,234) (5,882) (19,822) (25,704) $ $ FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) $ Sales Mine operating income Operating (loss) Income before income taxes and non-controlling interest Net (loss) for the year Condensed Consolidated Statement of Operations As at December 31, 2008 expressed in expressed in USD 000’S CAD 000’S 26,339 24,867 4,130 3,899 (5,925) (5,593) foreign currency translation at 1.05921 (1,472) (231) 332 $ $ 727 (964) (40) 54 687 (910) c) Adoption of New Accounting Standards i. Goodwill and Intangible Assets (Section 3064) In February 2008, the CICA issued the following Handbook Sections : Section 3064, “Goodwill and In- tangible Assets”, which replaces Section 3062, “Goodwill and Intangible Assets”, and Section 3450, “Research and Development Costs”, and amended Section 1000, “Financial Statement Concepts”. The standard intends to reduce the differences with International Financial Reporting Standards (“IFRS”) in the accounting for intangible assets and results in closer alignment with U.S. GAAP. Un- der previous Canadian standards, more items are recognized as assets than under IFRS or U.S. GAAP. The objectives of Section 3064 are to reinforce the principle-based approach to the recognition of as- sets only in accordance with the definition of an asset and the criteria for asset recognition; and clarify the application of the concept of matching revenues and expenses such that the current practice of recognizing assets that do not meet the definition and recognition criteria are eliminated. The standard also provides guidance for the recognition of internally developed intangible assets (including research and development activities), ensuring consistent treatment of all intangible assets, whether separately acquired or internally developed. This standard is effective for fiscal years beginning on or after Oc- tober 1, 2008. The Company has evaluated the new section and determined that adoption of these new requirements did not have a material impact on the Company’s consolidated financial statements. ii. Credit risk and fair value of financial assets and financial liabilities In January 2009, the Emerging Issues Committee of the CICA issued EIC-173 “Credit Risk and the Fair Value of Financial Assets and Financial Liabilities”. This guidance clarified that an entity’s own credit risk and the credit risk of the counterparty should be taken into account in determining the fair value of financial assets and financial liabilities including derivative instruments, for presentation and disclosure purposes. The guidance is to be applied retrospectively without restatement of prior periods to all financial assets and liabilities measured at fair value in interim and annual financial statements for periods ending on or after the date of issuance of this Abstract. Retrospective application with restatement of prior periods is permitted but not required. The Company has evaluated the new section and determined that adoption of these new requirements did not have a material impact on the Company’s consolidated financial statements. iii. Mining Exploration Costs On March 27, 2009, the Emerging Issues Committee of the CICA issued EIC-174 “Mining Exploration Costs” which applies to interim and annual financial statements for periods ending on or after January 1 6 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts 20, 2009. This guidance clarified that an entity that has initially capitalized exploration costs has an obligation in the current and subsequent accounting periods to test such costs for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The Company has adopted this new standard in its December 31, 2009 annual financial statements with no impact on the Company’s consolidated financial statements. iv. Financial Instruments - Disclosure In 2009, the Accounting Standards Board (“AcSB”) amended CICA Handbook Section 3862, Financial Instruments - Disclosures (“Section 3862”), to require enhanced disclosures about liquidity and about the relative reliability of the data, or “inputs”, that an entity uses in measuring the fair values of its financial instruments. The new requirements are effective for annual financial statements for fiscal years ending after September 30, 2009. The Company has adopted this new standard in its December 31, 2009 annual financial statements. d) Use of estimates The preparation of financial statements in conformity with Canadian GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabili- ties, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates are: quantities of proven and probable silver reserves; the value of mineralized material beyond proven and probable reserves; future costs and expenses to produce proven and probable reserves; future commodity prices and foreign currency exchange rates; the future cost of asset retirement obligations; amounts of contingencies; and the fair value of acquired assets and liabilities including pre-acquisition contingencies. Significant items that require estimates as the basis for determining the stated amounts include inventories, trade accounts receivable, mineral properties, property, plant and equipment, investments in non-producing properties, revenue recogni- tion, stock-based compensation, unrealized gains and losses on commodity contracts, fair value of assets and liabilities acquired in a business combination, and taxes. e) Revenue Recognition Revenue arising from the sale of metal concentrates is recognized when title and the significant risks and rewards of ownership of the concentrates have been transferred to the buyer. The passing of title to the customer is based on the terms of the sales contract and final commodity prices are set on a specified quotational period, either one or three months after delivery at the option of the customer. The Company’s metal concentrates are provisionally priced at the time of sale based on the prevailing market price. Variations recorded between the price recorded at the time of provisional settlement and the actual final price are caused by changes in metal prices. f) Cash Cash which is designated as held-for-trading financial assets and measured at fair value, include cash on hand and demand deposits. g) Short term investments Short term investments, which are designated as held-for-trading financial assets and measured at fair value, include bank notes, guaranteed investment certificates, term deposits, and money market instruments with maturities greater than 90 days, but less than one year, from the date of acquisition. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) h) Long term investments Long term investments are those investments which the Company will be retaining for a period longer than one year. These investments are classified as available-for-sale and are recorded at fair value. i) Property, Plant and Equipment Property, plant and equipment are recorded at cost and are depreciated over the estimated economic life of the asset on a straight line basis as follows: Buildings, mine site Buildings, other Machinery and equipment Furniture and other equipment Transport units Life of mine 6 - 20 years 3 - 8 years or Life of mine 3 - 13 years 4 - 5 years The expected remaining life of Caylloma mine as at December 31, 2009 is 8.3 years. Land is not depreciated. Equipment under capital lease is initially recorded at the present value of minimum lease payments at the inception of the lease. Spare parts and components included in ma- chinery and equipment, depending on the replacement period of the initial component, is depreciated over 8 to 18 months. j) Depletion and Mineral Properties Cost The Company defers the cost of acquiring, maintaining its interest, exploring, and developing mineral properties until such time as the properties are placed into production, abandoned, sold or considered to be impaired in value. General exploration costs that do not relate to a property where the Company has a vested interest are expensed as incurred. Costs of producing properties are depleted on a unit-of- production basis over proven and probable reserves and costs of abandoned properties are written-off. Proceeds received from the sale of interests in mineral properties are credited to the carrying value of the mineral properties, with any excess included in operations. Write-downs due to impairment in value are charged to operations. Significant payments related to the acquisition of land and mineral rights are capitalized as incurred. Prior to acquiring such land or mineral rights, the Company makes a preliminary evaluation to deter- mine that the property has significant potential to develop an economic ore body. The time between initial acquisition and full evaluation of a property’s potential is dependent on many factors including location relative to existing infrastructure, the property’s stage of development, geological controls, and metal prices. If a mineable ore body is discovered, such costs are amortized when production commences. If no mineable ore body is discovered, such costs are expensed in the period in which it is determined the property has no future economic value. In countries where the Company paid Value Added Tax (“VAT”) and where there is uncertainty of its recoverability, the VAT payments are capitalized with mineral property costs relating to the property or expensed if the exploration costs have been ex- pensed according to our accounting policy. If the Company recovers amounts that have been deferred, the amount received will be applied to reduce mineral property costs or taken as a credit against cur- rent expenses depending on the prior treatment. 3 6 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts k) Operational Mining Properties and Mine Development For operating mines all exploration within the mineral deposit is capitalized and depleted on a unit-of- production basis over proven and probable reserves as part of the production cost. Costs associated with commissioning activities on constructed plants are deferred from the date of mechanical completion of the facilities until the date the Company is ready to commence commercial production. Any revenues earned during this period are recorded as a reduction in deferred commis- sioning costs. These costs are depleted using the units-of-production method over the life of the mine, commencing on the date of commercial service. l) Asset Impairment Management reviews and evaluates its long-lived assets for impairment when events or changes in cir- cumstances indicate that the related carrying amounts may not be recoverable. Impairment is consid- ered to exist if total estimated future cash flows or probability-weighted cash flows on an undiscounted basis are less than the carrying amount of the assets, including mineral property, plant and equipment and producing and non-producing properties. An impairment loss is measured and recorded based on discounted estimated future cash flows or the application of an expected present value technique to estimate fair value in the absence of a market price. Future cash flows are based on recoverable proven and probable reserves and a portion of recoverable resources, silver, zinc, copper, lead and gold prices (considering current and historical prices, price trends and related factors), production levels, capital and reclamation costs, all based on detailed engineering life-of-mine plans. Assumptions underlying future cash flow estimates are subject to risks and uncertainties. Any differences between significant assumptions and market conditions and/or the Company’s per- formance could have a material effect on any impairment provision, and on the Company’s financial position and results of operations. In estimating future cash flows, assets are grouped at the lowest levels for which there are identifiable cash flows that are largely independent of cash flows from other groups. Generally, in estimating future cash flows, all assets are grouped at a particular mine for which there is identifiable cash flow. m) Asset Retirement Obligation The fair value of an obligation associated with the retirement of a tangible long-lived asset is recorded in the period in which it is incurred and a reasonable estimate of the fair value can be made, with a cor- responding increase to the carrying amount of the related asset. The liability is accreted over time for changes in the fair value of the liability through charges, which are included in depletion, depreciation, and accretion expense. The costs capitalized to the related assets are amortized in a manner consistent with the depletion and depreciation of the related assets. n) Inventories Inventories include metals contained in concentrates, stockpile ores, and operating materials and supplies. The classification of metals inventory is determined by the stage at which the ore is in the production process. Inventories of ore are sampled for metal content and are valued based on the lower of actual production costs incurred or estimated net realizable value based upon the period end- ing prices of contained metal. Mined material that does not contain a minimum quantity of metal to cover estimated processing expense to recover the contained metal is not classified as inventory and is assigned no value. 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts Ore stockpile and finished goods inventories are valued at the lower of production cost and net realiz- able value. Materials and supplies are valued at the lower of average cost and net realizable value. Production costs include all mine site costs. o) Income Taxes The Company uses the asset and liability method of accounting for income taxes in accordance to the CICA Handbook Section 3465 “Income Taxes”. Under the asset and liability method, future tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Future tax assets and liabilities are measured using substantively enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on future tax assets and liabilities of a change in tax rates is recognized in income in the year that includes the date of substantive enactment. Future tax assets are recognized to the extent that they are considered more likely than not to be realized. p) Stock-based Compensation The Company has a share option plan which is described in Note 16. d). The Company records all stock-based compensation relating to options granted using the fair value method such that stock- based payments are measured at fair value and expensed over their vesting period with a corresponding increase to contributed surplus. Upon exercise of share purchase options, the consideration paid by the option holder, together with the amount previously recognized in contributed surplus, is recorded as an increase to share capital. q) Earnings (loss) per Share Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. The diluted earnings (loss) per share calculation is based on the weighted average number of common shares outstanding during the period, plus the effects of dilutive common share equivalents. This method requires that the dilutive effect of outstanding options and warrants issued should be calcu- lated using the treasury stock method. This method assumes that all common share equivalents have been exercised at the beginning of the period (or at the time of issuance, if later), and that the funds obtained thereby were used to purchase common shares of the Company at the average trading price of the common shares during the period, but only if dilutive. r) Foreign Currency Translation Fortuna Silver Mines Inc.’s functional currency is the Canadian dollar. Effective January 1, 2009, the Company changed its reporting currency to the US dollar. All subsidiaries, except its wholly owned subsidiary, Bateas, are considered to be self sustaining op- erations. Bateas’s integrated foreign operations and their financial statements are translated to US dollars under the temporal method. Monetary assets and liabilities denominated in foreign currencies are translated at the exchange rate in effect at the balance sheet date and non-monetary assets and liabilities at historical exchange rates. Revenues and expenses are translated at the average exchange rate in effect during the period. Realized and unrealized foreign exchange gains and losses are in- cluded in earnings. 5 6 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts Commencing January 1, 2009, Bateas is an integrated foreign operation because Bateas translates its financial statements denominated in Peruvian Soles to US dollars using the temporal method. All other subsidiaries’ financial statements are translated using the current rate method. Assets and liabilities are translated into US dollars using the current rate method at period-end exchange rates and resulting translation adjustments are reflected in comprehensive income. Revenues and expenses are translated at average exchange rates for the period. s) Financial Instruments The Company applies as prescribed Section 3855, “Financial Instruments - Recognition and Measure- ment”. CICA Standard 3855 establishes standards for recognizing and measuring financial assets, financial liabilities, and non-financial derivatives. Under CICA 3855, all financial assets must be classi- fied as either held-for-trading, available-for-sale, held-to-maturity investments or loans and receivables. All financial liabilities must be classified as held-for-trading or other financial liabilities. All financial instruments, including derivatives, are included on the Consolidated Balance Sheets and are measured at fair value, except for held-to-maturity investments, loans and receivables, and other financial li- abilities, and these are all measured at amortized cost. The carrying value of receivables, and accounts payable and accrued liabilities approximate their fair value because of the short-term maturity of those instruments. Subsequent measurements and recognition of changes in fair value depend on the instru- ment’s initial classification. Held-for-trading financial instruments are measured at fair value, and all gains and losses are included in net income (loss) in the period in which they arise. Available- for-sale financial instruments are measured at fair value, determined by published market prices in an active market, except for investments in equity instruments that do not have quoted market prices in an active market which are measured at cost. Changes in fair value are recorded in other comprehensive income (loss) until the assets are removed from the balance sheet. Investments classified as available-for-sale are written down to fair value through income whenever it is necessary to reflect other than-temporary impairment. Realized gains and losses on the disposal of available-for-sale securities are recognized in investment and other income. Also, transaction costs related to all financial assets and liabilities are recorded in the acquisition or issue cost, unless the financial instrument is classified as held-for-trading or other liabilities, in which case the transaction costs are recognized immediately in net income (loss). CICA Handbook Section 3855 also requires financial and non-financial derivative instruments to be measured at fair value and recorded as either assets or liabilities. Certain derivatives embedded in non- derivative contracts must also be measured at fair value. Any changes in the fair value of recognized derivatives are included in net income (loss) for the period in which they arise, unless specific hedge accounting criteria are met, as defined in CICA Section 3865. The same accounting treatment applied to these non-financial derivative contracts prior to the adoption of CICA Section 3855. Fair values for the Company’s recognized commodity-based derivatives are based on the forward prices of the associ- ated market index. 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts The Company has designated each of its significant categories of financial instruments as follows: Financial Instrument Cash Short term investments Accounts receivable Long term receivables Long term investments and receivables Derivatives Accounts payable and accrued liabilities Due to related parties, net Long term liability Classification Held-for-trading Held-for-trading Loans and receivables Loans and receivables Available for sale Held-for-trading Other liabilities Other liabilities Other liabilities Measurement Fair value Fair value Amortized cost Amortized cost Fair value Fair value Amortized cost Amortized cost Amortized cost t) Derivatives and Trading Activities The Company employs metals contracts, including forward contracts to manage exposure to fluctua- tions in metal prices. For metals production, these contracts are intended to reduce the risk of falling prices on the Company’s future sales. All derivative instruments are recorded on the balance sheet at fair value. Unrealized gains and losses on derivative instruments are marked to market at the end of each accounting period with the results included in gain or loss on commodity and foreign currency contracts in the Consolidated Statement of Operations. u) Comparative figures Certain comparative figures have been reclassified to conform with the presentation adopted for the current year. In particular, certain balance sheet items were condensed. v) Recently released Canadian Accounting Standards The Company has assessed new and revised accounting pronouncements that have been issued and determined that the following may have an impact on the Company: i. Convergence with International Financial Reporting Standards (“IFRS”) In 2006, the Canadian Accounting Standards Board (“AcSB”) published a new strategic plan that will significantly affect financial reporting requirements for Canadian companies. The AcSB strategic plan outlines the convergence of Canadian GAAP with International Financial Reporting Standards (“IFRS”) over an expected five year transitional period. In February 2008, the AcSB announced that 2011 is the changeover date for publicly-listed companies to use IFRS, replacing Canadian GAAP. This date is for interim and annual financial statements relating to fiscal years beginning on or after January 1, 2011. The Company will begin reporting its financial statements in accordance with IFRS on January 1, 2011, with comparative figures for 2010. The adoption date of January 1, 2011 will require the restatement, for comparative purposes, of amounts reported by the Company for its year ended December 31, 2010, and of the opening balance sheet as at January 1, 2010. 7 6 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts ii. Business Combinations In January 2009, the CICA issued the following Handbook Sections: Section 1582, “Business Combi- nations”, Section 1601, “Consolidated Financial Statements”, and Section 1602, “Non-controlling In- terests”. These new standards are harmonized with International Financial Reporting Standards (IFRS). Section 1582 specifies a number of changes, including: an expanded definition of a business, a re- quirement to measure all business acquisitions at fair value, a requirement to measure non-controlling interests at fair value, and a requirement to recognize acquisition-related costs as expenses. Section 1601 establishes the standards for preparing consolidated financial statements. Section 1602 speci- fies that non-controlling interests be treated as a separate component of equity, not as a liability or other item outside of equity. The new standards will become effective in 2011 but early adoption is permitted. The Company is evaluating the attributes of early adoption of this standard and its potential effects if events or transactions occurred that this standard applies to. iii. Comprehensive revaluation of assets and liabilities and Equity In August 2009, the CICA amended Handbook Section 1625, “Comprehensive revaluation of assets and liabilities” as a result of issuing “Business Combinations, Section 1582, “Consolidated Financial Statements”, Section 1601, and Non-Controlling Interests”, Section 1602, in January 2009. In August 2009, the CICA amended Handbook Section 3251, “Equity” as a result of issuing Section 1602, “Non-controlling Interests”. These amendments only apply to entities that have adopted Sec- tion 1602. These amendments apply prospectively to comprehensive revaluations of assets and liabilities occur- ring in fiscal years beginning on or after January 1, 2011, but early adoption is permitted. The Com- pany is evaluating the attributes of early adoption of this standard and its potential effects if events or transactions occurred that this standard applies to. iv. Financial Instruments and Impaired Loans In August 2009, the CICA issued amendments to Section 3855, “Financial Instruments: Recognition and Measurement”. These amendments will permit (or require in certain circumstances) entities to reclassify certain investments in debt instruments, will amend the guidance regarding impairment measurement for Held-to-Maturity debt instruments and will require reversals of impairment losses for Available for Sale debt instruments when conditions have changed. These amendments apply only to investments in debt instruments and do not apply to investments in equity investments or to debt instruments that have been designated at origination as Held-for-Trading. In August 2009, the CICA amended Section 3025, “Impaired loans” to conform with the definition of a loan to that in amended Section 3855 and to include held-to-maturity investments within the scope of this Section. These amendments are effective for annual financial statements relating to fiscal years beginning on or after November 1, 2008 with early adoption permitted for interim financial statements issued on or after August 20, 2009. The Company has evaluated the new section and determined that adoption of these new requirements, for fiscal year end December 31, 2009, did not have a material impact on the Company’s consolidated financial statements. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 03. ACQUISITION OF MINING INTEREST On March 6, 2009, the Company closed the acquisition of all the issued and outstanding shares of Continuum which had 124,037,920 shares outstanding as of March 6, 2009. The Company agreed to issue to the Continuum shareholders a total of 6,995,738 shares, which is an exchange ratio of ap- proximately 0.0564 of a share of the Company for every one Continuum share held. As Fortuna held 3,706,250 common shares of the issued and outstanding share capital of Continuum as at March 6, 2009, those shares were cancelled and Fortuna issued a total of 6,786,674 shares to the Continuum shareholders other than Fortuna. As a result of the acquisition of Continuum, Fortuna now owns 100% of the San Jose Project in Oaxaca, Mexico. The acquisition is being accounted for as a purchase of assets. The following calculations include the fair value of Fortuna shares issued, based on the issuance of 6,786,674 Fortuna shares at CAD$0.98 per share for consideration of $5,194 (CAD$6,651). A valuation date of March 6, 2009 was deter- mined for the share value. The difference between the purchase consideration and the fair values of Continuum’s other assets and liabilities has been allocated to “Mineral properties”. The fair value of all identifiable assets and liabilities acquired was determined by a valuation effective March 6, 2009. No future tax asset has been recorded. The resulting “negative” purchase price discrepancy would have resulted in a future tax asset as it is more likely than not that this will not be recovered. The purchase price allocation is as follows Purchase Price 6,786,674 common shares of Fortuna Acquisition costs Loan to Continuum Cost of shares previously acquired Total purchase price Purchase Price allocation Net assets acquired Cash received Property, plant & equipment Mineral property interests Accounts payable and accrued liabilities Net identifiable assets of Continuum $ $ $ $ 5,194 113 3,184 130 8,621 5 6 8,749 (139) 8,621 Included as part of the mineral property interests purchased was the Predilecta project in Mexico with a value of $87 at acquisition date. As a result of the acquisition of Continuum, the non-controlling interest previously in Cuzcatlan was eliminated. 9 6 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F 04. SHORT TERM INVESTMENTS All amounts expressed in thousands of US Dollars, except for share and per share amounts December 31, 2009 December 31, 2008 Held-for-Trading Short term investments Fair Value 6,034 6,034 $ $ Cost 6,034 6,034 $ $ Accumulated unrealized holding gains (losses) Fair Value Cost $ $ - $ - $ - $ - $ Accumulated unrealized holding gains (losses) - - - $ - $ 05. DERIVATIVES During the year, the Company entered into commodity forward and option contracts to secure a mini- mum price level on part of its Caylloma’s zinc and lead metal production throughout the period covering February 2009 to December 2010 with the objective of securing short term capital requirements for project development. The counterparties are Standard Bank PLC, Banco Bilbao Vizcaya Argentaria, S.A., Macquarie Bank Limited, Goldman Sachs, and Scotia Bank. Forward Sales Contracts - Swap Basis The contracts are spread evenly over the periods shown below with settlement occurring on a monthly basis. No initial premium associated with these trades has been paid. The following forward sale contracts were entered into on a SWAP basis, as defined below: January 2009 - settlements throughout February 2009 to July 2009: • Lead forward contracts: $1,109/t, for the total of 3,150 tons • Zinc forward contracts: $1,240/t, for the total of 3,850 tons July 2009 - settlements throughout August 2009 to December 2009: • Lead forward contracts: $1,645/t, for the total of 2,675 tons • Zinc forward contracts: $1,561/t, for the total of 3,000 tons August 2009 - settlements throughout January 2010 to June 2010: • Lead forward contracts: $1,910/t, for the total of 1,800 tons • Zinc forward contracts: $1,787/t, for the total of 1,050 tons The SWAP basis contracts are settled against the arithmetic average of zinc and lead spot prices over the month in which the contract matures. Put and Call Option Commodity Arrangements As at December 31, 2009, the Company had entered into a series of put and call option commodity arrangements. A long put refers to put options that have been bought by the Company, and a short call refers to call options that have been sold by the Company. Settlement of these options occurs monthly during the period of January 2010 to December 31, 2010 as follows: 05. DERIVATIVES (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts Period January 2010 - June 2010 The following Zinc Option contracts were entered into: • • 6 Long put options at strike price: 6 Short call options at strike price: $2,000/t, for the total of 2,100 tons $3,010/t, for the total of 2,100 tons The following Lead Option contracts were entered into: • • 6 Long put options at strike price: 6 Short call options at strike price: $2,000/t, for the total of 1,200 tons $2,975/t, for the total of 1,200 tons Period July 2010 - December 2010 The following Zinc Option contracts were entered into: • • 6 Long put options at strike price: 6 Short call options at strike price: $2,000/t, for the total of 3,150 tons $3,010/t, for the total of 3,150 tons The following Lead Option contracts were entered into: • • 6 Long put options at strike price: 6 Short call options at strike price: $2,000/t, for the total of 2,850 tons $2,974/t, for the total of 2,850 tons The estimated fair value of the outstanding derivative contracts of ($3,055) (2008: $1,418) was determined with reference to the published market prices for underlying commodities quoted at the London Metal Exchange. 06. ACCOUNTS RECEIVABLE AND PREPAID EXPENSES Trade accounts receivable Advances and other receivables Prepaid expenses and deposits December 31, 2009 7,154 $ 1,168 313 $ 8,635 December 31, 2008 - $ 1,701 164 1,865 $ Accounts receivable and prepaid expenses include prepaid income tax of $9 (2008: $605), $121 (2008: $102) short term portion of the long term receivable, $34 (2008: $33) in guaranteed deposits. Trade accounts receivable includes receivables from the sale of concentrates of $7,154 (2008: $nil) and are aged less than 30 days. 07. INVENTORIES Inventories consist of the following: Stockpile ore Concentrate inventory Materials and supplies December 31, 2009 204 $ 651 1,474 $ 2,329 December 31, 2008 322 $ 90 1,315 1,727 $ 1 7 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts 08. LONG TERM INVESTMENT AND RECEIVABLE As at December 31, 2008, the Company had an investment in 3,706,250 shares of Continuum Re- sources Ltd. (“Continuum”). The Company measures these investments at fair value and this was determined based on published share prices of underlying securities on the active market. In addition, the Company had granted a loan to Continuum under the terms of the agreement by which Fortuna acquired all of the issued and outstanding shares of Continuum. This amount was used by Continuum to meet its share of the San Jose project capital contributions as well as general corporate expenditures. As at March 6, 2009, the Company closed the acquisition of Continuum as discussed in Note 3. Investment in shares in Continuum Loan to Continuum Receivables December 31, 2009 - $ - 16 16 $ December 31, 2008 91 $ 3,002 114 3,207 $ 09. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are comprised of the following: $ Land Buildings Machinery & equipment Equipment under capital lease Furniture & other equipment Transport units Work in progress $ $ December 31, 2009 Accumulated Depreciation - $ 1,040 3,023 568 438 239 - $ 5,308 $ Cost 316 4,740 10,152 3,249 1,627 430 2,027 22,541 December 31, 2008 Accumulated Depreciation Net Book Value 316 $ Cost 231 $ 3,700 7,129 2,681 1,189 191 2,027 17,233 3,410 7,867 1,615 1,193 526 1,354 $ 16,196 $ Net Book Value 231 2,808 6,163 1,399 975 355 1,354 13,285 - $ 602 1,704 216 218 171 - 2,911 $ Machinery & equipment includes costs of $526 (2008: $nil) and accumulated depreciation of $131 (2008: $nil) resulting from the estimate for the asset retirement obligation. Mineral properties are located in Peru and Mexico and are comprised of the following: December 31, 2009 December 31, 2008 10. MINERAL PROPERTIES Caylloma, Peru San Jose, Mexico Predilecta, Mexico Net Book Value Cost Depletion $ 42,209 $ 11,685 44,745 109 - - Write-off $ Cost Depletion 160 $ 30,364 $ 32,915 $ 7,154 $ - - 43,654 33,809 - 109 - 1,091 $ 87,063 $ 11,685 $ 1,251 $ 74,127 $ 66,724 $ 7,154 $ Write-off Net Book Value - $ 25,761 33,524 - 285 $ 59,285 285 - a) Caylloma Project, Peru For the year ended December 31, 2009, additions to the Caylloma mineral property includes development and exploration costs of $5,178, an increase of $944 resulting from a revision to the estimate for the asset retirement obligation, and $160 write off of exploration costs. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 10. MINERAL PROPERTIES (continued) b) San Jose Project, Mexico For the year ended December 31, 2009, additions to the San Jose mineral property consist of development and exploration costs capitalized of $5,742. Included in the additions for the San Jose property is $66 relating to the accretion of the payable for the Monte Alban II concession. This property was acquired for a total of $1,900 and consists of a payment of $1,100 made in May 2008 and a future payment of $800 is to be made in May 2012 (Note 13. b)). The present value of the $800 was $589 and this is being accreted monthly with the accretion amount being capitalized to the mineral property. Also included in additions to the San Jose mineral property is depreciation of equipment involved in construction work of $220 (2008: $181), and general and administrative costs to develop the mine of $1,425 (2008: $1,087), and $141 received as interest on VAT recovered. The San Jose Project is owned and operated by Cuzcatlan, a wholly owned subsidiary of the Company. In February 2009, the Company made effective a reduction of 8,344 ha out of the approximately 49,000 ha surrounding the San Jose project for which it holds exploration and mining rights. This resulted in a write-down of $1,091. This decision was based on existing geological information and is part of an effort to prioritize capital expenditures. c) Tlacolula Project, Mexico In September 2009, the Company, through its wholly owned subsidiary, Cuzcatlan, was granted an option to acquire a 60% interest in the Tlacolula silver project (“property”) located in the State of Oaxaca, Mexico from Radius Gold Inc.’s wholly owned subsidiary, Radius (Cayman) Inc. (“Radius”) (a related party by way of directors in common with the Company). The Company can earn the interest by spending $2,000, which includes a commitment to drill 1,500 meters within three years, and making staged annual payments of $250 cash and $250 in common stock of the Company to Radius according to the following schedule: • • • • • $20 cash and $20 cash equivalent in shares upon stock exchange approval; $30 cash and $30 cash equivalent in shares by the first year anniversary; $50 cash and $50 cash equivalent in shares by the second year anniversary; $50 cash and $50 cash equivalent in shares by the third year anniversary; and, $100 cash and $100 cash equivalent in shares by the fourth year anniversary. Upon completion of the cash payments and share issuances, and the incurring of the exploration expenditures as set forth above, the Company, will be deemed to have exercised the option and acquired a 60% interest in the property, whereupon a joint venture will be formed to further develop the property on the basis of the Company 60% and Radius 40%. As at December 31, 2009, the transaction is pending stock exchange approval and no payments have been made. On January 15, 2010, the transaction was approved by the TSX Venture Exchange, The Company has issued 7,813 common shares of the Company, at a fair market value of $2.56 per share and paid $20 cash according to the option agreement. 3 7 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts 11. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Trade accounts payable Income taxes payable Payroll and other payables December 31, 2009 2,577 $ 2,949 2,557 $ 8,083 December 31, 2008 $ 3,877 - 858 4,735 $ Payroll and other payables includes $1,084 (2008: $ nil) attributable to workers’ participation under Peruvian law. 12. RELATED PARTY TRANSACTIONS The Company incurred charges from directors, officers, and companies having a common director or officer as follows: Transactions with related parties Consulting fees 1 Salaries and wages 2,3 Other general and administrative expenses 3 Years ended December 31, $ 2009 145 122 159 $ 426 $ $ 2008 62 104 74 240 1 Consulting fees includes fees paid to two directors, Simon Ridgway and Mario Szotlender. 2 Salaries and wages includes employees’ salaries and benefits charged to the Company based on an estimated percentage of the actual hours worked for the Company. 2, 3 Radius Gold Inc. (“Radius”) has directors in common with the Company and shares office space, and is reimbursed for various general and administrative costs incurred on behalf of the Company. In September 14, 2009, the Company was granted an option to acquire a 60% interest in the Tlacolula silver project located in the State of Oaxaca, Mexico from Radius. Refer to Notes to the Consolidated Financial Statements Note 10. c). Amounts due to/(from) related parties Owing (from)/to a director and officer 4 Owing to a company with common directors 3 December 31, 2009 (1) $ 50 49 $ December 31, 2008 - $ 38 38 $ 4 Owing from a director includes a non-interest bearing loan to Jorge A. Ganoza Durant with no specific terms of repayments. The transactions with related parties are measured at the agreed upon exchange amount, which is the amount of consideration established and agreed upon by the parties. The balances with related parties are unsecured, non-interest bearing, and payable in the normal course of business. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 13. LEASES AND LONG TERM LIABILITIES a) Obligations under capital lease The following is a schedule of the Company’s capital lease obligations. These are related to the acquisition of mining equipment, vehicles, and buildings. Scotia Bank Banco Interamericano de Finanzas Scotia Bank Scotia Bank Scotia Bank Scotia Bank Scotia Bank Scotia Bank Scotia Bank Scotia Bank Interbank Interbank Interbank Interbank Lease payments Less current amount Interest Rate 9.29% 8.50% 8.20% 8.66% 8.20% 8.49% 8.34% 8.49% 6.75% 6.75% 4.00% 9.12% 9.75% 9.75% Maturity Date 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2011 2012 2012 $ December 31, 2009 - - - 101 252 57 14 100 16 20 198 170 91 829 1,848 (1,038) 810 $ $ December 31, 2008 14 $ 38 134 226 26 534 110 248 - - - 69 - - 1,399 (682) 717 $ $ b) Long term liability In November 2007, Bateas acquired the Minera Condor II and the Minera Condor III concessions for $250. A payment of $50 was made upon the signing of the contract, payments of $30 are required to be made every six months for a total of five payments, and $50 is required to be made November 2010. This contract was cancelled in March 2009 and the obligation of $156 recorded has been reversed. In May 2008, Cuzcatlan acquired the Monte Alban II concession (Note 10. b)) for which a payment of $800 is due May 2012. This payment is non-interest bearing and all debt relating to the acquisition of the mineral resource property has been recognized as at December 31, 2009. Face value of long term liability Less: adjustment to amortized cost Opening fair value of liability measured at amortized cost Cancellation of contract Add: accretion to period end Less: payments Liability at period end Less: current portion of long term liability December 31, 2009 970 (225) $ December 31, 2008 $ 1,000 (271) 745 (156) 55 - 644 - 644 $ $ 729 - 46 (30) 745 (80) 665 5 7 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F 14. ASSET RETIREMENT OBLIGATION All amounts expressed in thousands of US Dollars, except for share and per share amounts Principal minimum repayment terms will be: 2009 2010 2011 2012 $ $ - - - 800 800 c) Contingent liability The Caylloma mine closure plan was approved in November 2009 with the total closure costs of $3,346 of which $1,756 is subject to annual collateral in the form of a letter of guarantee, to be awarded each year in increments of $146 over 12 years, and is based on the life of the mine. Banco Bilbao Vizcaya Argentaria, S.A., a third party, has established a bank letter of guarantee on behalf of Bateas in favor of the Peruvian mining regulatory agency in compliance with local regulation associated with the approved Bateas’ mine closure plan, for the sum of $146. This bank letter of guarantee expires 360 days from December 2009. A summary of the Company’s provision for asset retirement obligation is presented below. Asset retirement obligation - beginning of year Revisions in estimates Accretion expense, included in depreciation, depletion and accretion Foreign exchange impact Asset retirement obligation - end of year December 31, 2009 1,066 $ 1,286 150 27 2,529 $ $ December 31, 2008 1,953 (589) 88 (386) 1,066 $ The accretion expense was calculated over the year using a risk free interest rate of 7.46%. The Company has reviewed its reclamation obligations at the property in light of changing regulations and on the basis of further data in respect of the mine life and has made an increase to the estimated amount of the asset retirement obligation of $1,286. In view of the uncertainties concerning environmental reclamation, the ultimate cost of reclamation activities could differ materially from the estimated amount recorded. The estimate of the Company’s asset retirement obligation relating to the Caylloma mine is subject to change based on amendments to laws and regulations and as new information regarding the Company’s operations becomes available. Future changes, if any, to the estimated liability as a result of amended requirements, laws, regulations, operating assumptions, estimated timing and amount of obligations may be significant and would be recognized prospectively as a change in accounting estimate. Any such change would result in an increase or decrease to the liability and a corresponding increase or decrease to the mineral property, plant and equipment balance. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 15. INCOME TAX a) Income tax expense differs from the amount that would be computed by applying the Canadian statutory income tax rate of 30% (2008 - 31%) to loss before income taxes and non-controlling interest. The reasons for the differences are as follows: Income before income taxes and non-controlling interest Statutory income tax rate Expected income tax Items non-deductible (deductible) for income tax purposes Difference between Canadian and foreign tax rates Change in income tax rates Change in exchange rates Change in valuation allowance Total income taxes Represented by: Current income tax Future income tax $ December 31, 2009 6,312 $ 30% 1,894 948 1,130 346 818 733 5,869 $ $ December 31, 2008 686 $ 31% 212 715 191 206 143 232 1,699 $ $ $ 4,922 947 5,869 $ $ - 1,699 1,699 Current income taxes payable of $2,949 (2008: $nil) is included within accounts payable and accrued liabilities in Note 11. b) The tax effects items that give rise to significant portions of the future tax assets and future tax liabilities at December 31, 2009 and 2008 are presented below: Future income tax assets: Non-capital losses Share issue costs Unrealized foreign exchange losses and other Financial derivatives Mineral properties and property, plant and equipment Total future income tax assets Valuation allowance Net future income tax assets Future income tax liabilities: Mineral properties – Peru Mineral properties – Mexico Unrealized foreign exchange gains and other Net future income tax liabilities Net future income tax liabilities December 31, 2009 December 31, 2008 $ 5,416 275 207 1,125 927 7,950 (6,599) 1,351 $ 2,204 352 272 - 1,261 4,089 (2,142) 1,947 $ $ $ (10,366) (1,958) - (12,324) (10,973) $ $ $ (8,498) (1,743) (1,116) (11,357) (9,410) 7 7 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts The Company has non-capital loss carry-forwards that will expire if unused of $20,931 that may be available for tax purposes. The loss carry-forwards expire as follows: Non-capital losses, expiring as follows: 2013 2014 2016 2017 2025 2026 2027 2028 2029 No expiry Canada 362 1,076 960 - 2,039 2,233 3,669 1,364 4,508 - 16,211 $ $ Peru $ - $ - - - - - - - $ 870 870 $ Mexico - - 15 2,848 - - - - 987 - 3,850 A full valuation allowance has been recorded against the potential future income tax assets associated with the Canadian loss carry-forwards as their utilization is not considered more likely than not at this time. 16. SHARE CAPITAL a) Authorized: Unlimited common shares without par value On June 17, 2009, an aggregate of 36 common shares resulting from rounding of previous capital consolidations were returned to treasury to reduce the accumulated fractional shares held in the Company’s trustee account. Subsequent to December 31, 2009, the Company issued 7,813 common shares, at a fair market value of CAD$2.63 per share, to Radius (refer to Note 10.c)) and issued 15,007,500 common shares at a price of CAD$2.30 per shares, under the bought deal financing (refer to Note 22.c)), and 64,500 share purchase options were exercised at CAD$0.85 per share, resulting in issued and outstanding shares of 110,062,465. b) Stock Options The following is a summary of option transactions: Balance, December 31, 2007 Granted Exercised Expired Forfeited Balance, December 31, 2008 Granted Exercised Expired Forfeited Balance, December 31, 2009 Number of Shares 6,686,400 2,655,000 (31,400) - (1,576,000) 7,734,000 2,915,000 (389,000) (970,000) (1,075,000) 8,215,000 $ Weighted Average Exercise Price Per Share in CAD$ 2.24 1.03 1.22 - 2.77 1.87 1.56 0.81 2.35 3.22 1.50 $ $ FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 16. SHARE CAPITAL (continued) During the period, 970,000 share purchase options with exercise prices ranging from CAD$0.85 to CAD$3.22 per share expired unexercised, 389,000 share purchase options were exercised at exercise prices ranging from CAD$0.37 to CAD$0.85 per share. During the period, the Company granted to officers and employees an aggregate of 2,915,000 share purchase options with exercise prices ranging from CAD$0.83 to CAD$2.23 per share, exercisable for ten years, vesting from 4 months or immediately. As at December 31, 2009, 2,665,000 share purchase options are subject to shareholder approval. The following share purchase options were outstanding at December 31, 2009: Number of Shares 30,000 270,000 250,000 60,000 200,000 20,000 225,000 860,000 225,000 110,000 700,000 50,000 15,000 5,000 50,000 30,000 25,000 250,000 150,000 1,125,000 650,000 250,000 2,150,000 490,000 25,000 8,215,000 Exercise Price CAD$ $ 0.80 $ 1.35 $ 2.29 $ 1.75 $ 1.75 $ 0.85 $ 1.55 $ 1.66 $ 1.61 $ 0.85 $ 2.22 $ 2.75 $ 0.85 $ 0.85 $ 0.85 $ 0.85 $ 0.85 $ 2.52 $ 1.25 $ 0.85 $ 0.85 $ 0.83 $ 1.60 $ 1.70 $ 2.23 Expiry Date July 24, 2010 February 5, 2016 March 30, 2016 May 8, 2016 May 22, 2016 July 5, 2016 July 5, 2016 July 10, 2016 September 13, 2016 January 11, 2017 January 11, 2017 February 6, 2017 April 22, 2017 May 31, 2017 June 27, 2017 July 2, 2017 October 24, 2017 February 5, 2018 August 25, 2018 October 5, 2018 November 5, 2018 July 6, 2019 October 27, 2019 November 8, 2019 November 23, 2019 Weighted Average Remaining Contractual Life -Years 0.6 6.1 6.2 6.4 6.4 6.5 6.5 6.5 6.7 7.0 7.0 7.1 7.3 7.4 7.5 7.5 7.8 8.1 8.7 8.8 8.9 9.5 9.8 9.9 9.9 8.29 As at December 31, 2009, 8,215,000 share purchase options have vested with 2,665,000 share purchase options subject to shareholder approval. Subsequent to December 31, 2009 to March 11, 2010, 64,500 share purchase options were exercised at CAD$0.85 per share. 9 7 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts c) Warrants The following is a summary of share purchase warrant transactions: Balance, December 31, 2007 Issued Exercised Expired Balance, December 31, 2008 Issued Exercised Expired Balance, December 31, 2009 Number of Share Purchase Warrants 16,479,375 - (4,322,596) (1,093,424) 11,063,355 - (2,475,355) (8,588,000) - Weighted Average Exercise Price Per Share Purchase Warrant in CAD$ 1.89 $ - 1.85 2.30 1.86 - 0.35 2.30 - $ $ d) Stock-based Compensation The Company has established a formal stock option plan in accordance with the policies of the TSX Venture Exchange under which it is authorized to grant options up to 10% of its outstanding shares to officers, directors, employees, and consultants, and is subject to shareholder approval. The exercise price of each option must not be less than the closing market price of the Company’s shares on the trading day immediately prior to the date of grant. The options are for a maximum term of ten years. The Company uses the fair value based method of accounting for share options granted to consultants, directors, officers, and employees. The non-cash compensation charge of $2,707 recognized for the year ended December 31, 2009 (2008: $1,348) is associated with the granting of options to a consultant, directors and employees. These compensation charges have been determined under the fair value method using the Black-Scholes option pricing model with the following assumptions: Risk-free interest rate Expected stock price volatility Expected term in years Expected dividend yield Years ended December 31, 2009 2.42% - 3.45% 70% - 78% 5 & 10 0% 2009 2.57% - 3.97% 62% - 78% 2, 3, 5 & 10 0% The weighted average grant date fair value of options granted during the year ended December 31, 2009 was CAD$0.91 (2008 - CAD$0.57). Option pricing models require the input of highly subjective assumptions including the estimate of the share price volatility, risk-free interest rate and expected life of the options. Changes in the subjective input assumptions can materially affect the fair value estimate, and therefore the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s stock options. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 16. SHARE CAPITAL (continued) e) Reserves During the year, the Board of Directors of Bateas has appropriated reserves of $1,130 (2008: $nil) from its retained earnings representing ten percent of the net income earned in the calendar years 2006, 2007, and 2008. The reserve is required under the Republic of Peru’s General Corporate Law (Ley General de Sociedades) article 229, whereas a legal reserve equivalent to a minimum of ten percent of the distributable value of each financial year, net of income taxes until the reserve reaches an amount equal to one fifth of its capital (capital defined as share capital and retained earnings) must be established. The excess over this limit is not a legal reserve. Dividends can only be paid on profits free of reserves. 17. SEGMENTED INFORMATION a) Industry Information The Company operates in one reportable operating segment, being the acquisition, exploration, development, and operation of mineral properties. b) Geographic Information The following is the summary of operations and summary of certain assets on a geographical basis. Canada Peru Mexico Other Total $ $ $ $ Year ended December 31, 2009 Sales Operating income (loss) Year ended December 31, 2008 Sales Operating (loss) income As at December 31, 2009 $ Mineral Properties Property, plant and equipment $ Total assets As at December 31, 2008 Mineral Properties Property, plant and equipment $ Total assets $ $ $ - (5,612) - (4,294) - 11 25,120 - 4 25,071 $ $ 51,428 20,992 $ $ - $ (921) $ - $ (76) $ 51,428 14,383 $ $ 24,867 (947) - $ $ $ (329) $ - $ (23) $ 24,867 (5,593) $ $ $ $ $ $ 30,364 12,298 67,978 $ $ $ 43,763 $ 4,922 $ 46,614 $ - $ 2 $ 26 $ 74,127 17,233 139,738 25,761 9,105 46,124 $ 33,524 $ $ 4,174 $ $ 41,348 $ - $ 2 $ 2,825 $ 59,285 13,285 115,368 c) Major Customers For the year ended December 31, 2009 and 2008, there was one customer accounting for 94% and 100% of total sales of the Company, respectively. 18. COMMITMENTS AND CONTINGENCIES The Company has a contract to guarantee power supply at its Caylloma mine. Under the contract, the seller is obligated to deliver a “maximum committed demand” (for the present term this stands at 2,800 Kw) and Bateas is obligated to purchase subject to exemptions under provisions of “Force Majeure”. The contract is automatically renewed every two years for a period of 10 years. Renewal can be avoided without penalties by notifying 10 months in advance of renewal date. Tariffs are established yearly by the energy market regulator in accordance with applicable regulations in Peru. The Company acts as guarantor to capital lease obligations held by two of its mining contractors. These capital lease contracts are related to the acquisition of mining equipment deployed at the Caylloma mine. As at December 31, 2009, these obligations amounted to $1,075 and mature in 2010. 1 8 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts a) Environmental Matters The Company’s mining and exploration activities are subject to various laws and regulations governing the protection of the environment. These laws and regulations are continually changing and are generally becoming more restrictive. The Company conducts its operations so as to protect the public health and environment and believes its operations are in compliance with applicable laws and regulations in all material respects. The Company has made, and expects to make in the future, expenditures to comply with such laws and regulations, but cannot predict the full amount of such future expenditures. Estimated future reclamation costs are based principally on legal and regulatory requirements. As of December 31, 2009 and 2008, $2,529 and $1,066, respectively, were accrued for reclamation costs relating to mineral properties in accordance with Section 3110, “Asset Retirement Obligations”. See Note 13. c) and 14. b) Income Taxes The Company operates in numerous countries around the world and accordingly it is subject to, and pays annual income taxes under the various income tax regimes in the countries in which it operates. Some of these tax regimes are defined by contractual agreements with the local government, and others are defined by the general corporate income tax laws of the country. The Company has historically filed, and continues to file, all required income tax returns and to pay the taxes reasonably determined to be due. The tax rules and regulations in many countries are highly complex and subject to interpretation. From time to time, the Company is subject to a review of its historic income tax filings and in connection with such reviews, disputes can arise with the taxing authorities over the interpretation or application of certain rules to the Company’s business conducted within the country involved. c) Title Risk Although the Company has taken steps to verify title to properties in which it has an interest, these procedures do not guarantee the Company’s title. Property title may be subject to, among other things, unregistered prior agreements or transfers and may be affected by undetected defects. 19. CAPITAL DISCLOSURE The Company’s objectives when managing capital are to provide shareholder returns through maximization of the profitable growth of the business and to maintain a degree of financial flexibility relevant to the underlying operating and metal price risks while safeguarding the Company’s ability to continue as a going concern. The capital of the Company consists of shareholders’ equity and the line of credit, net of cash. The Board of Directors does not establish a quantitative return on capital criteria for management. The Company manages the capital structure and make adjustments to it in light of changes in economic conditions and the risk characteristics of the underlying assets. The management of the Company believes that the capital resources of the Company as at December 31, 2009, are sufficient for its present needs for the next 12 months. The Company’s overall strategy with respect to capital risk management remained unchanged during the year. The Company is not subject to externally imposed capital requirements. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 20. MANAGEMENT OF FINANCIAL RISK The Company’s financial instruments are exposed to certain financial risks, including currency risk, credit risk, liquidity risk, interest risk, and price risk. The Company’s Board of Directors has overall responsibility for the establishment and oversight of the Company’s risk management framework and reviews the Company’s policies on an ongoing basis. a) Fair value of financial instruments The Canadian Institute of Chartered Accountants (“CICA”) Handbook Section 3862 “Financial Instruments - Disclosure” requires disclosure of a three-level-hierarchy for fair value measurements based upon transparency of inputs to the valuation of financial instrument carried on the balance sheet at fair value. The three levels are defined as follows: • • • Level 1 - inputs to the valuation methodology are quoted (unadjusted) for identical assets or liabilities in active markets. Level 2 - inputs to valuation methodology include quoted market prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value of measurement. The carrying value of cash, short term investments, accounts receivable, accounts payable and accrued liabilities, due to related parties, net, approximate their fair value due to the relatively short periods to maturity and the terms of these financial instruments. Fair value estimates are made a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgement and, therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The Company has classified the determination of fair value of accounts receivable, and derivatives as level 2, as the valuation method used by the Company includes an assessment of assets in quoted markets with significant observable inputs. Short term investments Accounts receivable Derivatives Financial assets (liabilities) at fair value as at December 31, 2009 Total 6,034 8,322 (3,055) 11,301 Level 3 - - - - Level 2 - 8,322 (3,055) 5,267 Level 1 6,034 - - 6,034 $ $ $ $ $ $ $ $ 1 Comparative information has not been presented in the table because this information is not required in the year of adoption. For periods subsequent to the year of adoption comparative information would be necessary. Accounts receivable includes accounts receivable from provisional sales. The fair value of accounts receivable resulting from provisional pricing reflect observable market commodity prices. Resulting fair value changes accounts receivable are through sales. Transactions involving accounts receivable are with counterparties the Company believes are creditworthy. 3 8 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F All amounts expressed in thousands of US Dollars, except for share and per share amounts Derivatives are carried at their fair value, which is determined based on internal valuation models that reflect observable forward market commodity prices. Resulting fair value changes to derivatives are through net gain(loss) on commodity contracts. Transactions involving derivatives are with counterparties the Company believes to be creditworthy. b) Currency risk The Company is exposed to the financial risk related to the fluctuation of foreign exchange rates. The Company operates in Canada, Peru, Mexico and Barbados and a portion of its expenses are incurred in Canadian dollars, Nuevo Soles, and Mexican Pesos. A significant change in the currency exchange rates between the United States dollar relative to the other currencies could have a material effect on the Company’s results of operations, financial position or cash flows. The Company has not hedged its exposure to currency fluctuations. As at December 31, 2009, the Company is exposed to currency risk through the following assets and liabilities denominated in Canadian dollars, Nuevo Soles and Mexican Pesos (all amounts are expressed in thousands of Canadian dollars, thousands of Nuevo Soles or thousands of Mexican Pesos): Cash Short term investments Accounts receivable Accounts payable and accrued liabilities Canadian Dollars 21,283 S/. 560 5 $ December 31, 2009 Nuevo Soles Mexican Pesos 1,283 - 6,565 302 $ - 880 December 31, 2008 Canadian Dollars $ 29,748 - 13 S/. Nuevo Soles 629 $ - 10,400 Mexican Pesos 3,864 - 46,460 (194) (17,150) (623) (172) (5,281) (10,259) Based on the above net exposure as at December 31, 2009, and assuming that all other variables remain constant, a 10% depreciation or appreciation of the US dollar against the above currencies would result in an increase or decrease expressed in US dollars, as follows: Impact to other comprehensive income (loss) Impact to net income (loss) (614) $ 2,293 $ 65 $ c) Credit risk Credit risk is the risk of an unexpected loss if a customer or third party to a financial instrument fails to meet its contractual obligations. The Company’s cash equivalents and short term investments are held through large Canadian, international and foreign national financial institutions. These investments mature at various dates within one year. All of the Company’s trade accounts receivables are held with large international metals trading companies. The Company holds derivative contracts with financial institutions and in this regard is exposed to counterparty risk. The Company mitigates this risk by transacting only with reputable financial institutions to minimize credit risk. As at December 31, 2009, the Company has a Mexican value added tax of $421 and Peruvian value added tax of $176. The Company expects to recover the full amounts from the Mexican and Peruvian Governments. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2009 AND 2008 All amounts expressed in thousands of US Dollars, except for share and per share amounts 20. MANAGEMENT OF FINANCIAL RISK (continued) d) Liquidity risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they fall due. The Company manages liquidity risk by continuing to monitor forecasted and actual cash flows. The Company has in place a planning and budgeting process to help determine the funds required to support the Company’s normal operating requirements on an ongoing basis and its development plans. The Company strives to maintain sufficient liquidity to meet its short term business requirements, taking into account its anticipated cash flows from operations, its holdings of cash, short term investments, and its committed liabilities. The Company expects the following maturities of its financial liabilities (including interest), operating lease and other contractual commitments: Accounts payable and accrued liabilities Due to related parties, net Derivatives Long term liability Total1 Expected payments due by period as at December 31, 2009 Less than 1 year 8,083 $ 49 3,055 1,038 12,225 $ 1-3 years - - - 1,454 1,454 $ $ 4-5 years - $ - - - - $ $ $ After 5 years - $ - - - - $ Total 8,083 49 3,055 2,492 13,679 1 Amounts above do not include payments related to the following: (i) the Company’s anticipated asset retirement obligation of $2,529 associated with mine closure, land reclamation, and other environmental matters. e) Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The risk that the Company will realize a loss as a result of a decline in the fair value is limited because the balances are generally held with major financial institutions in demand deposit accounts. f) Metal price risk The Company is exposed to metals price risk with respect to silver, gold, zinc, and lead sold through its mineral concentrate products. The Company mitigates this risk by implementing price protection programs for some of its zinc and lead production through the use of derivative instruments. As a matter of policy, the Company does not hedge its silver production. A 10% change in zinc, lead, silver, gold, and copper prices would cause an $811, $848, $1,528, $149, and $27 change in net earnings, respectively. 5 8 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F 21. SUPPLEMENTAL CASH FLOW INFORMATION All amounts expressed in thousands of US Dollars, except for share and per share amounts Supplementary disclosure of cash flow information: Cash received or paid for interest and income taxes: Cash received for interest Cash paid for income taxes Non-cash Transactions Issue of share on purchase of resource property Reassessment of asset retirement obligation Cancellation of Minera Condor liability Equipment purchase through capital lease Purchase of resource property on a deferred payment plan Sale of equipment for a long-term receivable Fair value of options exercised Notes 10 10,14 13 b) Years ended December 31, 2009 210 596 5,194 1,286 156 1,425 - - 246 $ $ $ $ $ $ $ $ $ 2008 $ (1,417) 479 $ $ $ $ $ $ $ $ - - - - 860 143 25 22. SUBSEQUENT EVENTS UP TO MARCH 11, 2010 a) Credit Facility On January 6, 2010, the Company has signed a commitment letter to enter into a $20 million senior secured revolving credit facility with The Bank of Nova Scotia. The facility will have a 2.5 year maturity. The proceeds of the facility may be used for general corporate purposes, including the development of the San Jose Project in Mexico. The facility is intended to complement Fortuna’s strong cash position and provide additional financing flexibility during the construction stage at San Jose. The San Jose pre-feasibility study is scheduled to be concluded the first quarter of 2010. b) Exchange listing The Company’s common shares were listed and begun trading on the Toronto Stock Exchange (TSX) at the opening of trading on Monday, January 18, 2010 under its current symbol “FVI”. Fortuna’s common shares were delisted from the TSX Venture Exchange upon commencement of trading on the TSX. c) Other On February 3, 2010, the Company (“Fortuna”) entered into a bought deal financing (“Offering”) with a syndicate of underwriters co-led by CIBC and Canaccord Financial Ltd. The Offering closed on March 2, 2010 and the Company issued 15,007,500 common shares at a price of CAD$2.30 per shares (refer to Note 16.a) under the bought deal financing for gross proceeds of CAD$34.5 million. Net proceeds of CAD$32.8 million after underwriting fees of CAD$1.7 million were raised from the bought deal financing. The Company intends to use the net proceeds from the Offering to partially fund the construction of its 100% owned San Jose project in the state of Oaxaca, Mexico and for general corporate purposes. BUILDING THE FOUNDATIONS OF A LEADING SILVER MINER 7 8 t r o p e R l a u n n A 9 0 0 2 . c n I s e n i M r e v l i S a n u t r o F 1 2 1. Caylloma Mine: Animas Vein 2. Vancouver, Canada CORPORATE INFORMATION Corporate Office: 355 Burrard Street, Suite 840 Vancouver, BC Canada, V6C 2G8 Tel: +1.604.484.4085 Management Head Office: Piso 17. Av. Pardo y Aliaga # 640 San Isidro, Lima - Peru Tel: +51.1.616.6060, ext. 2 Investor Relations Corporate Office Erin Ostrom / Ralph Rushton Management Head Office Carlos Baca info@fortunasilver.com Stock Exchanges: TSX: FVI Lima Stock Exchange: FVI Frankfurt: F4S.F OTC:BB: FVIT.F Auditors: Deloitte & Touche LLP Chartered Accountants 2800 – 1055 Dunsmuir Street 4 Bentall Centre P.O. Box 49279 Vancouver, BC Canada V7X 1P4 Share Transfer Agent: Olympia Trust Company 925 West Georgia Street, Suite 1900 Vancouver, BC Canada V6C 3L2 Qualified Person Mr. Miroslav Kalinaj, P. Geo., is the Company’s Qualified Person as defined by the NI 43 - 101 and is responsible for the accuracy of the technical information in this annual report. www.fortunasilver.com TSX: FVI Lima Stock Exchange: FVI Frankfurt: F4S.F OTC:BB: FVIT.F Photo: Caylloma Mine: Animas Vein 

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