Fortuna Silver Mines
Annual Report 2010

Plain-text annual report

F O R T U N A S I LV E R M I N E S I N C . / 2 0 1 0 A N N U A L R E P O R T Exceeding Objectives Exceeding Objectives pg.04 2011 - 2015 Production Forecast pg.05 Mid-Term Strategy pg.09 pg.11 Mineral Reserves and Mineral Resources Chief Executive Officer’s Letter pg.15 Social Responsibility pg.17 Caylloma Mine, Peru pg.21 San Jose Mine, Mexico pg.27 Silver Analysis pg.14 Chairman´s Letter pg.29 Financial Review 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, uncertainties 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. Cover Photo: Caylloma Mine- Bateas vein workers / Photo: San Jose Mine- Crushing circuit FORTUNA SILVER MINES INC. remains one of the industry’s most efficient and lowest cost silver producers and an outstanding performer amongst its peer companies. As a result, the Company’s operational team is gaining recognition as one of the best operators and mine developers in the emerging producer sector. During 2010, Fortuna capitalized on rising silver and base metal prices and realized its best performance to date in earnings and operating margins. Annual silver production at Fortuna’s Caylloma Mine in Peru has continually exceeded forecasts and increased by more than 250% over the past three years to 1.9 million ounces. With commissioning of the Company’s San Jose Mine in Mexico, planned for the third quarter of 2011, Fortuna offers one of the most exciting organic production growth profiles amongst emerging silver producers, ensuring increasing leverage to rising silver prices. >> 02 Corporate Office Vancouver, Canada Management Head Office Lima, Peru San Jose Project Oaxaca, Mexico (Silver, Gold) Caylloma Mine Caylloma, Peru (Silver, Lead, Zinc, Copper) 2010 highlights FINANCIAL HIGHLIGHTS (000’s) Expressed in US dollars Sales Operating Income (loss) Net Income (loss) Earnings (loss) per share, basic and diluted Net cash provided by operating activities Cash position OPERATING HIGHLIGHTS Tonnes milled Average tonnes milled per day (tpd) Production (metal contained) Silver (oz) (*) Gold (oz) (*) Lead (000 lbs) Zinc (000 lbs) Copper (lbs) Unit Cash Cost and Net Smelter Return Unit cash cost (US$/oz Ag**) Unit cash cost (US$/tonne) Unit NSR (US$/tonne) Realized Price (**) Silver (US$/oz) Lead (US$/lb) Zinc (US$/lb) Copper (US$/lb) Gold (US$/oz) No. of Employees 2010 $ 74,056 30,111 12,955 0.12 21,109 90,087 2009 $ 51,428 14,383 623 0.01 13,686 36,796 2008 $ 24,867 (5,593) (910) (0.01) 8,356 na 2010 434,656 1,231 2009 395,560 1,121 2008 331,381 936 1,906,423 2,556.05 21,373 26,137 1,026 1,682,546 2,780.07 25,137 28,442 190 (7.73) 51.20 163.59 19.05 0.80 0.60 2.67 939.45 (4.86) 46.27 124.07 13.75 0.61 0.42 1.59 812.08 1,630 1,185 805,057 2,196.67 16,502 23,283 na (3.78) 46.41 87.00 na na na na na 885 03 CAPITAL STRUCTURE HIGHLIGHTS Share Structure (as of April 1, 2011) Outstanding Options: 4.1 million Warrants: 0 Issued Capital: 122.9 Million Fully Diluted: 127.1 Million Exchanges TSX: FVI BVL: FVI Frankfurt: F4S.F OTC:BB: FVIT.F Average Trading Volume (3 month) 816,000 shares Market Capitalization (as of April 14, 2011) CND$771.8 million 52-week Price Range CND$6.81 – $1.85 FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT Notes:(*) 2010, 2009 Ag and Au production in Pb and Cu. 2008 Ag and Au production in Pb.(**) Considers deductions, treatment, and refining charges as applicable 2010 Milestones: Higher Income, Production and Declining Cash Costs Net income of US$12.96 million, compared with US$0.62 million in 2009 n Sales of US$74.06 million, compared with US$51.43 million in 2009; 44% increase n Record silver production at Caylloma: 1.9 million ounces n Production of 26.1 million pounds of zinc, 21.4 million pounds of lead and 1 million pounds of copper as by-products n Caylloma’s cash cost per silver ounce drop to negative US$7.73, net of by-product credits n San Jose on track to produce 542,420 ounces of silver and 4,816 ounces of gold or 824,158 silver equivalent ounces* in 2011 and 2.75 million silver equivalent ounces in 2012 n Two bought-deal financings raised more than CND$80 million n Cash position (including short-term investments and working capital) at year end: US$90.81 million and US$97.09 million respectively. 2011-2015 Production Forecast n Caylloma Mine (Ag - Au) n San Jose Mine (Ag - Au) n Caylloma Mine Base Metal (Ag Eq) 10 z o M 9 8 7 6 5 4 3 2 1 0 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 04 Photo: San Jose Mine- Ocotlan grey water treatment plant (*) Based on Ag= US$ 23.60/oz, Au= US$ 1,350/oz and metallurgical recoveries of 88% and 90% for Ag and Au respectively1. Ratios for silver equivalency have been derived using the following metal prices: Au: US$1,350/oz, Ag: US$35/oz, Zn: US$2,400/t, Pb: US$2,400/t2. Metal production forecast based on Mineral Reserves published in news release dated April 12th, 2011 OUR VISION: To be valued as a leading silver mining company centered on developing natural resources in Latin America; operating with a commitment to profitability, growth, high standards and the well being of our work- ers, neighboring communities and the environment. Fortuna Silver Mines’ Philosophy OUR MISSION: To create shareholder value through the rational acquisition, exploration, development and mining of silver in Latin America with a commitment to sustainable growth of reserves and annual metal production. To promote a stimulating work environment of high-standards and best-practices which fosters respect, team work, social and environmental responsibility. OUR VALUES (1) We value the environment: We subscribe to the highest environmental standards (2) We value the health and safety of our workers: We will not tolerate insecure acts or conditions (3) We value our neighbors and other stakeholders: We have respect for cultural di- versity and will work as a strategic partner towards the sustainable development of neighboring communities (4) We value the courage to introduce change: We will break industry paradigms (5) We value integrity: We do what we say we will do OUR MID-TERM STRATEGY n Target 14 million silver equivalent ounces in production and development by 2015, 7 million silver equivalent ounces from current reserves and plans plus 7 million silver equivalent from new ounces n Focus on Latin America n Focus on silver, no less than 40% of value n Focus on high margin operations below the median for industry cost. Photo: Processing plant concentrate/tailings thickeners and water tanks 05 JORGE A. GANOZA DURANT President, CEO and Director CESAR F. PERA CACERES Vice President, Human and Organizational Development MANUEL RUIZ-CONEJO CARLOS Vice President, Project Development JORGE R. GANOZA AICARDI Vice President, Operations Dr. THOMAS I. VEHRS Vice President, Exploration LUIS DARIO GANOZA DURANT Chief Financial Officer 06 2011 Production Guidance Mine Silver (oz) Gold (oz) Zinc (lbs) Lead (lbs) Copper (lbs) Caylloma, Peru 1,900,000 2,950 25,200,000 16,600,000 760,000 San Jose, Mexico 542,420 4,580 -- -- -- Total : 2,442,420 7,530 25,200,000 16,600,000 760,000 Core Assets at a Glance CAYLLOMA Ag-Pb-Zn-Cu MINE – AREQUIPA, PERU Low-cost, underground vein mine in operation since late 2006. Produces silver, gold, lead, zinc and copper from 1,250 tonnes per day operation. Silver production currently optimized at 1.9 million ounces. In 2010, silver accounted for 48% of revenue and gold 3%, the balance being base metals. Our Peruvian subsidiary employs approximately 1,050 workers. SAN JOSE Ag-Au MINE – OAXACA, MEXICO Underground vein mine scheduled to initiate commercial operations in the third quarter of 2011 at a rate of 1,000 tonnes per day, increasing to 1,500 tonnes per day in late 2013. 2011 production forecast of 542,420 ounces of silver plus 4,816 ounces of gold or 824,158 silver equivalent ounces. For 2012, production forecast of 1.79 million ounces of silver plus 16,283 ounces of gold or 2.75 million silver equivalent ounces. Our Mexican subsidiary currently employs approximately 500 workers out of which 40% come from surrounding communities. EXPLORATION AND RESERVE REPLACEMENT In 2009 and 2010, we successfully replaced reserves consumed through production at Caylloma and believe that with our improving understanding of ore controls in the district, we should be able to continue to add to the reserve and resource base. FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT 07 Both Caylloma and San Jose offer excellent potential for expansion of our current reserves and resources. Both Caylloma and San Jose offer excellent potential for expansion of our current reserves and resources. Fortuna Silver has an aggressive Brownfields exploration program for 2011 with a budget of US$12.5 million, including more than 30,000 meters of exploration drilling at Caylloma and San Jose. If successful, these exploration programs could have a material impact on expansion plans for the two operations. At the Caylloma Mine, the Company is targeting the lateral and depth extensions of the principal veins in the southern portion of the district. Targets have been defined at the northeast extension of the San Cristobal vein where the projection of the vein is covered by post- mineral rock units. Similarly, drilling will further test the northeast extension of the Animas vein where prior drilling in 2007 and 2008 intersected ore-grade mineralization in the Nancy structure, a subsidiary structure to the Animas Vein. Exploration drilling will also test the northeast extension of the Bateas Vein near its projected intersection with the San Cristobal Vein. Both the Bateas and the San Cristobal veins have been prominent producers of high-grade silver ores throughout the history of the Caylloma District. Our geologists will also explore the La Plata Vein which is sub-parallel to the Animas Vein. Limited past drilling of the La Plata Vein has encountered high-grade silver mineralization over vein widths ranging to 2.65 meters. At the San Jose Project, drilling targets have been defined along the southern strike extension of the San Jose deposit and in association with multiple vein targets in the Taviche Mining District located approximately 12 kilometers to the northeast of San Jose. Drilling is also planned in the El Rancho area, on-trend from the Taviche District, where geochemical surface sampling has identified a large Au-in-soil anomaly associated with strongly silicified and mineralized limestones stratigraphically beneath the volcanic sequence that is host to the vein-style mineralization present in the area. Additional exploration is planned to further evaluate previously identified stream sediment and soil anomalies located within Fortuna’s 58,000 hectare concession package. 08 Mineral Reserves and Mineral Resources MINERAL RESERVES – PROVEN AND PROBABLE Tonnes Property Classification (000) Ag (g/t) Au (g/t) Pb (%) Zn (%) Cont. Ag (Moz) Cont.Au (koz) Caylloma, Peru Silver Veins Proven Probable Proven + Prob. Polymetallic Veins Proven Probable Proven + Prob. Combined-All Veins Proven Probable Proven + Prob. San Jose, Mexico Probable Total Reserves Proven + Prob. 403 111 515 1,316 2,305 3,622 1,720 2,417 4,136 3,771 7,908 394 457 407 115 121 119 180 137 155 202 177 0.34 0.90 0.47 0.35 0.34 0.34 0.35 0.36 0.36 1.58 0.94 0.03 0.11 0.05 1.96 1.80 1.86 1.50 1.72 1.63 0.04 0.04 0.04 2.92 2.64 2.74 2.24 2.52 2.40 N/A  N/A  N/A  N/A  5.1 1.6 6.7 4.9 9.0 13.9 10.0 10.6 20.6 24.5 45.1 4.5 3.2 7.7 14.6 25.0 39.6 19.1 28.2 47.3 191.6 238.9 MINERAL RESOURCES – MEASURED AND INDICATED Property Classification (000) Ag (g/t) Au (g/t) Pb (%) Zn (%) Tonnes Cont. Ag (Moz) Cont. Au (koz) Caylloma, Peru Measured Indicated 463 1,423 Measured + Ind. 1,887 San Jose, Mexico Indicated 376 Total Measured + Ind. 2,263 94 131 122 243 142 0.27 0.33 0.31 2.12 0.61 1.00 0.84 0.88 N/A  N/A  1.66 1.37 1.44 N/A  N/A  1.4 6.0 7.4 2.9 10.4 4.1 14.9 18.9 25.6 44.6 MINERAL RESOURCES - INFERRED Tonnes Property Classification (000) Ag (g/t) Au (g/t) Pb (%) Zn (%) Cont. Ag (Moz) Cont. Au (koz) Caylloma, Peru Inferred San Jose, Mexico Inferred 3,332 3,074 119 222 0.35 1.80 09 Total Inferred 6,406 168 1.05 1.05 2.02 N/A  N/A  N/A  N/A  12.8 22.0 34.7 37.9 178.0 215.9 Notes: 1. Mineral Reserves and Mineral Resources are as defined by the CIM Definition Standards on Mineral Resources and Miner- al Reserves 2. Mineral Resources are exclusive of Mineral Reserves 3. Mineral Resources that are not Mineral Reserves do not have demonstrated economic viability 4. Caylloma Mineral Reserves are estimated and reported as of June 30, 2010 using break-even cut-off grades based on estimated NSR values using assumed metal prices of US$16.63/oz Ag, US$1066.68/oz Au, US$1984/t Pb and US$1962/t Zn; historic metallurgical recovery rates of 87% for Ag, 43% for Au, 91% for Pb and 89% for Zn; and historic operating costs adjusted for inflation. Caylloma Mineral Resources are reported as of June 30, 2010 based on estimated NSR val- ues using the aforementioned assumed metal prices and a cut-off grade of US$30/t 5. Caylloma Mineral Resources include oxide material that is not amenable to processing in the existing flotation plant. Measured and Indicated oxide resources are estimated at 831,100 tonnes averaging 200 g/t Ag, 0.38 g/t Au, 1.10% Pb and 1.30% Zn. Inferred oxide resources are estimated at 677,000 tonnes averaging 176 g/t Ag, 0.30 g/t Au, 0.50% Pb and 0.91% Zn 6. San Jose Reserves are estimated and reported as of Dec. 31, 2010 using break-even cut-off grades based on assumed metal prices of US$15.12/oz Ag and US$897.51/oz Au, estimated metal- lurgical recovery rates of 88% for Ag and 90% for Au and projected operating costs. San Jose Resources are estimated and reported at a Ag Equivalent cut-off grade of 100 g/t, with Ag Eq in g/t = Ag (g/t) + Au (g/t) * ((US$856.16/US$13.75) * (91.5/92.5)) = Ag (g/t) + Au (g/t)*61.6 7. Totals may not add due to rounding procedures 8. N/A = Not Applicable FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT                 Exceeding Objectives On Track to Becoming a Leading Silver Miner in Latin America 10 Photo: San Jose Mine- Mine development Chief Executive Officer’s Letter DEAR SHAREHOLDERS 2010 has been with other structural changes, will assist us in another year of accomplishment for Fortuna continuing to mobilize our organization to as we reported record financial performance, achieve sustainable long term growth. driven by increases in production and metal prices, with net earnings of US$0.12 per GROWING OUR BUSINESS Over the course of share. We realized an average silver price the last four years we have been diligently de- of US$19 dollars per ounce during the year ploying capital to build a base of reserves that and are well positioned to continue benefi- have taken us to 45.1 million ounces of silver ting from the surge in silver price. Under the and 239,000 ounces of gold at both Caylloma theme of “building a leading silver miner” we and San Jose. This allows us to project the have been carrying initiatives in 2010 and life of each of our mines to over eight years into 2011, to continue delivering growth in and support an annual production rate of 6.5 resources, reserves and silver production with million silver equivalent ounces (from silver an emphasis on remaining as one of the and gold) starting in 2013. Our challenge now lowest cost silver producers. Cash cost per sil- is to continue fuelling growth organically and ver ounce in 2010 was negative US$7.73 per through corporate transactions. ounce net of by product base metal credits. Exploration successes will likely lead to further 11 incremental metal production growth For 2011, we have allocated US$12.5 mi- llion dollars to brownfields exploration around our mines in Peru and Mexico. Exploration successes will likely lead to further incre- mental metal production growth. In addition, we continue actively searching for new silver business opportunities in Latin America. Our business development efforts for a material In 2010, the Company incorporated a new acquisition are centered in Mexico and Peru set of values to meet the challenges of our and over the past months, we have evaluated growing business: value for the environment, opportunities in Argentina, Chile, Ecuador value for the health and safety of our workers, and Colombia. Apart from the inherent cha- value for surrounding communities and stake- llenge of discovery, we are in a very com- holders along with the courage to introduce petitive market. We rely on the skills of our change and integrity. This, in concurrence exploration team as well as on our regional FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT expertise to gain a competitive advantage San Jose into production in the third quarter in our search for Fortuna´s next asset. of 2011, execute our planned exploration programs and meet sustaining capital require- BUILDING OUR ORGANIZATION As a growth ments of our Caylloma Mine. Our excess cash company in a dynamic market, our organiza- will allow us to aggressively pursue new busi- tion is faced with a constant state of change. ness opportunities in Latin America. In 2010 and early 2011 we incorporated four key positions to Fortuna´s executive team. THE SAN JOSE AG-AU MINE: PLANNED The position of Vice President of Human COMMERCIAL PRODUCTION FOR THIRD and Organizational Development will play a QUARTER 2011 The San Jose Mine strategic role in supporting our growth stra- construction continues advancing within tegy ensuring that we have the ability of not schedule and budget targeting the start of only attracting but also retaining talent in an commercial production for the third quarter extremely competitive job market. We also in- of 2011. Our 2011 budget to commission the corporated the positions of Corporate Manager mine is US$32 million dollars. for Financial Planning, reporting to the Chief Financial Officer; Corporate Resource Mana- As of March 2011 major processing plant ger and Brownfields Exploration Manager, both equipment has been mounted and installed. reporting to the Vice President of Exploration. This includes: three stage crushing circuit, FINANCIAL POSITION Fortuna enters 2011 conveyors, ball mill, flotation cells, thicke- with a solid balance sheet and a strong ners and water tanks. Key projects have been coarse and fine ore storage facilities and belt treasury. In cash and short term investments, concluded including the tailings and water 12 we hold approximately US$90 million dollars storage facilities, 8MW power substation and with no long term debt. During 2010, we the Ocotlan gray water treatment plant. Mine closed two successful bought deal equity development and preparation is advancing financings raising CDN$80.5 million; in according to plan with the aim of building a addition, we put in place a CDN$20 million 30,000 tonne ore stock pile by June and revolving credit facility with Scotiabank. being in a position to source 1,000 tonnes With cash on hand and cash flow projections per day starting in July. Our project and from our mines, we are adequately funded to construction teams continue delivering an meet all of our capital requirements to bring excellent performance at San Jose. >> Chief Executive Officer’s Letter Continued Photo: San Jose Mine- Processing plant ore transport conveyor belt system 13 OPERATING AND SAFETY PERFORMANCE I want to take the opportunity to commend We continue to excel as a low cost our operating and construction teams in underground silver miner. We produced Peru and Mexico for their commitment to a 1.9 million ounces of silver, 2,000 ounces safe work environment. In March 2011, we of gold, 21.4 million pounds of lead, 26.1 achieved 1,586,000 work time hours without million pounds of zinc and 1 million pounds any lost time accidents. of copper in 2010. Silver accounted for 48% of revenue with a cash cost of negative The most valuable asset of any company is its US$7.73 cents net of by product base people. I want to thank the continued sup- metals and gold. For 2011, we plan to port and leadership of the Board of Directors produce 2.8 million silver equivalent ounces and all our co-workers and contractors who’s (from silver and gold) at a negative cash efforts and dedicated work are contributing to cost net of by product base metal. build Fortuna into a leading silver miner. The most valuable asset of any company is its people. FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT Jorge A. Ganoza D. President, CEO and Director Chairman’s Letter EXCEEDING OBJECTIVES was an easy has brought us to this pivotal year. Fortuna’s choice for the title of this year’s annual silver production, revenue and cash flow report. It is after all management’s operating are set to grow significantly with the philosophy and it underpins their actions commissioning of the San Jose Mine in and decisions on a day to day basis. Your Mexico, pushing us ahead of many of our Company’s President, Jorge Ganoza Durant, peers in these three important metrics. made this his battle cry when we founded Fortuna Silver back in 2005 and he has Our growth to date has been organic. We instilled it in the management team he has so set out to build Fortuna through the drill bit. ably assembled in the years since then. We have excellent mineral deposits that I believe will keep growing even as they are being mined. And we have excellent people to explore, develop and mine those deposits and grow our Company. As the management and workers of Fortuna Silver continue to Exceed Objectives, so the Company will continue to outperform. I am grateful for how the Fortuna team has collectively embraced the Company’s goals and worked tirelessly to meet them. I believe we can all look forward to very positive years ahead. 14 Fortuna’s silver production, revenue and cash flow are set to grow significantly with the commissioning of the San Jose Mine in Mexico… As Fortuna Shareholders we can count ourselves lucky. It is the reason our Company is where it is today. 2011: A YEAR OF GROWTH. Exceeding Simon Ridgway objectives has served shareholders well and Chairman of the Board Social Responsibility WE ARE COMMITTED to contribute to sustainable economic development — working with employees, their families, the local community and society at large to improve the quality of life, in ways that are both good for business and good for human development in the countries where we operate. We firmly believe that effective and responsible environmental and social management will result in greater efficiency by minimizing risks, thus contributing to our long term success. Our corporate policies commit us to working under the following standards: n To operate in an ethical and legal manner, with transparency and accountability, seeking to ensure access to new resources and to manage our projects with environmental and social responsibility. n To develop the full potential of our employees. We respect and value each of our employees and observe the fundamental tenets of human rights, safety and non-discrim- ination in the workplace. n To responsibly manage all resources under our control by ensur- ing the conservation of the environment and the welfare of our workers and our neighboring communities. n To minimize environmental, health, and safety risks by ensuring that all government and corporate regulations and standards are satisfied. n To maintain participa- tory monitoring programs in our operations with local authorities and neighboring communi- ties to ensure permanent compliance with our policies for social and environmental respon- sibility and with government laws and regulations. n To periodically review all environmental, health and safety, and community relations systems, programs and regulations to guarantee continued improvement in the performance of our activities. n To keep our contractors and strategic partners informed and aligned with our Social Responsibility policy and programs. n To maintain open communications with regard to environmental, health, and safety matters with government authorities, shareholders, employees, communities in our areas of influ- ence, their authorities and other concerned stakeholders. FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT 15 Exceeding Objectives We Are Committed To Contribute to Sustainable Economic Development 16 Photo: Caylloma Mine- Tailings dam ichu replanting 17 Exceeding Objectives Low Cost Silver and Base Metal Producer FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT Photo: Caylloma Mine- 1,250 tpd processing plant Photo: Caylloma Mine- 4,500 m.a.s.l. mine camp Corporate Office Vancouver, Canada Caylloma Mine, Peru Corporate Office Vancouver, Canada MEXICO San Jose Project CONSTRUCTION Oaxaca, Mexico (Silver, Gold) MEXICO San Jose Project CONSTRUCTION Oaxaca, Mexico (Silver, Gold) Management Head Office Lima, Peru PERU Caylloma Mine PRODUCTION Caylloma, Peru (Silver, Lead, Zinc, Copper) Management Head Office Lima, Peru PERU Caylloma Mine PRODUCTION Caylloma, Peru (Silver, Lead, Zinc, Copper) COMMODITIES: Silver, Gold, Zinc, Lead, Copper LOCATION: Arequipa, Peru (Latitude 15° 13” S, Longitude: 71° 49” W) OWNERSHIP: 100% Lima DEPOSIT TYPE: Intermediate-sulfidation epithermal vein deposit STATUS: Mine and processing plant operating at 1,250 tpd >> 2011 EXPLORATION TARGETS San Cristobal Vein (NE extension), Bateas Vein (NE extension), La Plata Vein, Animas Vein (NE extension) SILVER PRODUCTION of 1,906,423 CAYLLOMA MINE 2010 PRODUCTION ounces, a 13% increase over the 1,682,546 ounces in 2009, exceeded 2010 guidance by 12%. This increase is attribu-table to an increase in mill throughput of 10%, an increase in silver recoveries of 0.3% and a 3% increase in silver head grade. Cash cost per payable ounce silver in Tonnes Milled Average tonnes milled per day Silver Grade (g/t) Recovery (%) Production (oz)* Lead Grade (%) Recovery (%) 2010 was negative US$7.73 net of Production (000’s lbs) by-product credits compared to negative US$4.86 in 2009. The change was attributable to increased revenue from by-product credits and increased payable silver ounces of 38% and 16%, respectively, offset by an 11% increase in refining charges. Zinc Grade (%) Recovery (%) Production (000’s lbs) Copper Production (000’s lbs) Unit Costs Production cash cost(US$/oz Ag)** Production cash cost(US$/tonne) Unit Net Smelter Return(US$/tonne) Years Ended December 31, 2009 2010 434,656 1,231 395,560 1,121 159.24 85.67 1,906,423 154.76 85.40 1,682,546 2.44 91.28 21,373 3.10 87.99 26,137 3.10 93.02 25,137 3.66 89.07 28,442 1,026 190 (7.73) 51.20 163.59 (4.86) 46.27 124.07 18 The mill treated 434,656 tonnes of ore in 2010, compared to 395,560 tonnes in the prior year. The cash cost per tonne was US$51.20 compared to US$46.27 in 2009. >> (*) Silver in lead and copper concentrates (**) Net of by-product credits Caylloma Mine, Peru Caylloma had a 13% increase in Silver production in 2010. Zinc and lead production during 2010 decreased by 8% and 15%, respectively, compared to 2009. This decrease was related to a shift in the mine plan designed to replace the polymetallic ore from the Animas vein with higher grade silver ore from level 6 in the upper part of the Animas vein. The mine plan shift was made because of lower than expected grades from the Bateas silver vein which lead to an acceleration of the incorporation of level 6 into the production plan. Photo: Caylloma Mine: Animas vein Cash cost per tonne of treated ore for the year 2010 increased by 11% to US$51.20 com- pared to 2009. The cost variation reflected a 2010 upward revision of underground mine contractor tariffs and labor costs directed towards reducing personnel rotation at operations, higher preparation and breakage costs at the mine, commencement of ore control drilling in 2010, local currency appreciation and preventive equipment maintenance plans that have been successful in increasing plant availability by 3% to 4%. 19 In 2010, 71% (2009: 85%) ore was sourced from the central and lower levels of Animas vein, 17% from level 6 in the upper part of Animas vein, and 11% (2009: 15%) from Bateas, Soledad, and Silvia veins. Total mine development and preparation in 2010 was 12,110 meters, 56% in the Animas vein and 44% in the high-grade silver veins. The main focus of development in the Animas vein was to extend mineralization along strike towards the northeast on levels 10 and 12, and preparation of resource blocks between level 10 and level 12 with infrastructure as the mine plan extends below level 10 in 2011. In the upper part of the Animas vein, develop- ment and preparation was focused on incorporating level 6 into the production plan. FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT In the high grade Soledad and Silvia silver veins mine development and preparation was aimed mainly below current working levels. In the high-grade Bateas vein exploration and development drifting focused on extending mineralization along strike to the east and resulted in the discovery of high-grade silver ore shoots on levels 10 and 12 as reported in the press release of December 15, 2010. The main capital projects executed in 2010 were a tailings reclassification plant for US$0.48 million, and the finalization of the feasibility study for the new tailings dam facility with an estimated total cost of US$4.2 million. The tailings reclassification plant will allow an increase in the percentage of tailings available for backfill material and the first stage of the new tailings dam will provide 7.5 years of life at current production levels. In January 2011, production of copper-silver concentrate was discontinued at Caylloma due to a material deterioration in commercial treatment terms with respect to 2010. The Company is monitoring market conditions to evaluate restarting the circuit. Copper accounted for 4% of sales in 2010 (2009: 1%). 20 Photo: Caylloma Mine: Caylloma mining district 21 Exceeding Objectives The San Jose Mine will be a Company Game Changer FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT Photo: San Jose Mine- 13´ x 19.5´ ball mill San Jose Mine, Mexico Corporate Office Vancouver, Canada Corporate Office Vancouver, Canada MEXICO San Jose Project CONSTRUCTION Oaxaca, Mexico (Silver, Gold) COMMODITIES: Silver, Gold LOCATION: MEXICO San Jose Project CONSTRUCTION Taviche Mining District, Oaxaca, Mexico Management Head Office Lima, Peru PERU Caylloma Mine PRODUCTION Caylloma, Peru (Silver, Lead, Zinc, Copper) (Latitude: 16° 41” N, Longitude: 96° 42” W) Oaxaca, Mexico (Silver, Gold) OWNERSHIP: 100% DEPOSIT TYPE: High-grade, low-sulfidation epithermal vein deposit Mexico City STATUS: - Construction of 1,500 tpd mine underway PERU Caylloma Mine PRODUCTION - Commissioning in Q3 2011 at 1000 tpd Management Head Office Lima, Peru Caylloma, Peru (Silver, Lead, Zinc, Copper) >> 2011 EXPLORATION PROJECTS San Ignacio, Taviche and El Rancho areas SAN JOSE MINE 2011 AND 2012 PRODUCTION FORECAST Year 2011 2012 Silver (oz) Gold (oz) Silver Equivalent (oz)* 542,420 1.79M 4,816 16,283 824,158 2.75M THE SAN JOSE Ag-Au MINE The Company anticipates that the San Jose Mine, currently under construction in Mexico, will begin to contribute both silver and gold ounces starting in the third quarter of 2011 allowing the Company to maintain its organic silver production growth in 2011. Construction Highlights as of March 23, 2011: n Processing plant construction is 33% complete. Foundation work for crushers, milling, flotation, thickening and filtering areas is complete. Mounting and installation of major 22 plant equipment was initiated in January 2011. The 13’ x 19.5’ ball mill has been mounted where the milling section is 42% advanced. The three stage crushing circuit is being mounted and installed with a 66% advance. Flotation cells have arrived on site and thickeners are being mounted and installed. n Tailings dam construction was concluded in January 2011. n The 8MW power substation construction and commissioning has been concluded; connection to the national grid is expected in March 2011. n The mine access ramp has reached the 1,400 meter elevation, where the first production level is being developed. >> (*) Based on Ag= US$ 23.60/oz, Au= US$ 1,350/oz and metallurgical recoveries of 88% and 90% for Ag and Au respectively San Jose Mine, Mexico Photo: San Jose Mine- Mine develoment n Three stopes are being developed and prepared for the start of production in the third quarter at the initial rate of 1,000 tpd; Stope K is being developed on the Trinidad, Fortuna and Bonanza veins on sublevel 1430. Stopes L and M are being developed on level 1400. Overall advance on stope preparation is 115% against the program. n To December 31, 2010 the mine had built an ore stock pile of 6,816 tonnes grading 234 g/t Ag and 2.13 g/t Au. The Company anticipates an inventory of approximately 30,000 tonnes before the start of commercial operations in the third quarter of 2011. n Water pipeline installation to the mine site is 87% advanced. 23 PROCESSING PLANT AND ANCILLARY FACILITIES Construction of the 1,500 tpd processing plant and ancilliary facilities are on schedule for commissioning at an initial rate of 1,000 tpd in the third quarter of 2011. The processing plant has no long lead equipment on criti- cal path. Purchase orders for all plant equipment have been placed with equipment arriving on-site according to schedule. Processing plant construction is 33% complete. Foundation work for crushers, milling, flotation, thickening and filtering areas is complete. Mounting and installation of major plant equipment was initiated in January 2011. The 13’ x 19.5’ ball mill has been mounted where the milling section is 42% advanced. The three stage crushing circuit is being mounted and installed with a 66% advance. Flotation cells have arrived on site and thickeners are being mounted and installed. FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT TAILINGS DAM Construction of the tailings dam was concluded in January 2011. The tailings dam is currently prepared to store water for the commissioning of the processing plant. Conagua (National Water Commission of Mexico responsible for the management and preservation of national waters and their inherent goods in order to achieve sustainable use, with joint responsibility of the three tiers of government - federal, state and municipal- and society as a whole) technical observations to the design of the tailings facility were addressed with state and federal Conagua authorities. The Company expects approval of the final Conagua permit in the coming weeks. UNDERGROUND MINE DEVELOPMENT In December, the main access ramp reached the 1400 meter elevation -the first production level- allowing for the development of production stopes K, L and M for start-up of production at an initial mining rate of 1,000 tonnes per day. Vein widths and grades for the Trinidad, Fortuna and Bonanza veins intersect on level 1400 and sublevel 1430 are in line with the geologic resource model. WATER SOURCING The Ocotlan grey water treatment plant is fully operational and the quality of the water obtained is within design parameters. The pipeline to carry water from the grey water treatment plant to the San Jose Mine site is 87% complete. Negotiations with a neighboring community are taking place to install the remaining two kilometers of the pipeline. Inflow to the process from the grey water treatment facility is required twenty months after the start of commercial operations. POWER SUBSTATION Construction of the transformer and switching stations has been completed. Commissioning has been concluded and connection to the national power grid in March, 2011. 24 Photo: San Jose Mine- Tailings Dam San Jose Mine Layout San Jose Mine will begin to contribute both silver and gold ounces starting in the third quarter of 2011 01 8 MW POWER SUBSTATION SWITCHING STATION / TRANSFORMER STATION 02 MAIN ACCESS RAMP 25 01 02 FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT 03 05 PROCESSING PLANT CRUSHING CIRCUIT 1,500 TPD PROCESSING PLANT ANCILLARY FACILITIES 03 04 05 04 26 Silver Analysis DUAL IDENTITY DRIVES PRICE DYNAMICS Silver prices averaged US$20.31 in 2010, a 38.4% increase over 2009 and second only to 1980’s average of US$20.65. Silver’s dual identity as both a precious and industrial metal continued to define its price performance. Thus the pricing dynamics remained much the same as in 2009: high investment demand and a recovering global economy. HIGH PRICES GENERATE RECORD SUPPLY Prices rose despite a 9.3% increase in total silver supply to a record 1.03 billion ounces and a continuing decrease in photography demand. The largest supply increase in 2010 came from secondary recovery, as the higher prices generated unprecedented levels of scrap and industrial recovery plus high sales of jewelry and silverware. New mine production also increased. RECOVERING ECONOMY AND SOLAR PANELS DRIVE FABRICATION INCREASE Increasing industrial activity worldwide and higher demand for consumer electronics produced a 9.5% increase in overall fabrication demand, from 864.8 million ounces in 2009 to 946.6 million ounces in 2010. The sharpest demand increase occurred in solar panel fabrication—the industry is estimated to have consumed 64 million ounces of silver in 2010, a 205% increase over 2009. $/Ounce 45 $/Ounce 45 THE PRICE OF SILVER (Monthly Average Comex, Through 13 April 2011) MM Oz 700 MM Oz 600 700 SILVER DEMAND AND SUPPLY BALANCE 500 600 400 500 300 400 200 300 100 200 0 100 0 07 07 08 08 09 09 10 10 11 11 MM Oz 700 MM Oz 600 700 500 600 400 500 300 400 200 300 100 200 0 100 0 WITE GLTR PSLV WITE 27 SVR.UN GLTR SBT.U PSLV JB SVR.UN SBT.U SIVR MSL JB ZKB SIVR PHAG MSL SLV ZKB CEF PHAG SLV CEF 06 06 $/Ounce 40 45 35 40 30 35 25 30 20 25 15 20 10 15 5 10 0 5 0 Million Ounces 1100 Million Ounces 1000 1100 900 1000 800 900 700 800 600 700 500 600 400 500 300 400 200 300 $/Ounce 40 45 35 40 30 35 25 30 20 25 15 20 10 15 5 10 0 5 0 Million Ounces 1100 Million Ounces 1000 1100 900 1000 800 900 700 800 600 700 500 600 400 500 300 400 200 300 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 Fabrication Demand Fabrication Demand Supply Supply 60 63 66 68 72 75 78 81 84 87 90 93 96 99 02 05 08 11p 200 200 60 63 66 68 72 75 78 81 84 87 90 93 96 99 02 05 08 11p FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT A NERVOUS WORLD PUSHES INVESTMENT DEMAND Investment demand also rose in 2010. Precarious political, debt and market forces continued to funnel cash into silver and gold as safe havens. Inflation and interest rate concerns, along with sovereign debt worries, remained key factors in the flight to safety which was marked by record purchases of ETF shares and silver coins. However, investment demand was also driven increasingly by speculation that fabrication demand will continue its climb. MEXICO: LARGEST SILVER PRODUCER IN THE WORLD Of interest in 2010 was Mexico’s rise to the world’s top silver producing country, overtaking Peru. Part of this surge was attributed to the opening of Goldcorp’s massive Penasquito mine and production increases at other major mines. 2011: MORE OF THE SAME Looking ahead, silver market dynamics for 2011 are likely to mirror those of 2010 and produce further increases in both demand and supply. Which force wins out as the primary market catalyst, however, is not as easy to predict. If inflation and interest rates trend higher, driven by both sovereign debt worries and recovering economies, silver may well reach record prices again in 2011. 64.0 Solar Panels 176.2 Other Uses FABRICATION DEMAND FOR SILVER Total Fabrication Demand for Silver in 2010: 844.8 Million Ounces 220.4 Electronics and Batteries ETF SILVER HOLDINGS Exchange Traded Funds’ Physical Silver Holdings Silver analysis and graphs provided MM Oz 700 600 500 MM Oz 700 400 600 300 500 200 400 100 0 300 200 100 0 103.4 Photography 280.8 Jewelry and Silverware MM Oz 700 600 500 400 300 200 100 0 MM Oz 700 600 500 400 300 200 100 0 11 $/Ounce 45 40 35 30 25 20 15 10 5 0 Million Ounces 1100 28 1000 900 $/Ounce 45 40 35 30 25 20 15 10 5 0 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 Fabrication Demand 800 700 600 500 400 300 200 Million Ounces 1100 1000 900 800 700 600 500 400 300 200 Fabrication Demand 60 63 66 68 72 75 78 81 84 87 90 93 96 99 02 05 08 11p Supply 60 63 66 68 72 75 78 81 84 87 90 93 96 99 02 05 08 11p $/Ounce 45 40 35 30 25 20 15 10 5 0 1100 1000 900 800 700 600 500 400 300 200 Million Ounces $/Ounce 45 40 35 30 25 20 15 10 5 0 900 800 700 600 500 400 300 200 Million Ounces 1100 1000 Supply WITE GLTR PSLV SVR.UN SBT.U JB SIVR MSL ZKB PHAG SLV CEF WITE GLTR PSLV SVR.UN SBT.U JB SIVR MSL ZKB PHAG SLV CEF 06 07 08 09 10 06 07 08 09 10 11 Fortuna Silver Mines Inc. Financial Review Fiscal Year Ended December 31, 2010 29 pg.30 Management’s Discussion and Analysis pg.56 Consolidated Financial Statements pg.62 Independent Auditor’s Report on Consolidated Financial Statements pg.86 Corporate Information FORTUNA SILVER MINES INC. 2010 ANNUAL REPORT FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the significant 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, 2010 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, 2009, the related MD&A, and Fortuna’s Annual Information Form (available on SEDAR at www.sedar.com). This MD&A refers to various 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 Company’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 document contains forward-looking statements. Please refer to the cautionary language under the heading “Cautionary Statement on Forward-Looking Information” below. BUSINESS OF THE COMPANY Fortuna Silver Mines Inc. (the “Company”) is a mining company focused on producing silver and base metals and developing 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 2010 HIGHLIGHTS Financial Results During the year ended December 31, 2010 the Company generated a net income of $12.96 million (2009: $0.62 million) on operating income of $30.11 million (2009: $14.38 million) and sales of $74.06 million (2009: $51.43 million). Record results were driven by increased silver production and higher silver and base metal prices. 30 Silver metal production during the year ended December 31, 2010 was 1,906,423 ounces, 13% above 2009. The increase was due to a combination of higher throughput (10%) and higher silver head grades (3%). Silver comprised 48% of revenue and the realized silver price was $19.05 per ounce. Cash cost per ounce, net of by-product credits, was negative $7.73. See the page 12 for reconciliation of cash cost to the cost of sales. Adjusting for the mark-to-market effect on commodity contracts and a foreign exchange loss on the repatriation of funds from the Company’s Peruvian subsidiary (included in the $2.70 million foreign exchange loss recorded for the year) 2010 adjusted net income (a non-GAAP measure) totalled $11.29 million (2009: $2.37 million). FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RECENT DEVELOPMENTS AND 2010 HIGHLIGHTS (continued) NET INCOME FOR THE YEAR Items of note, net of tax: Mark to Market effect on derivatives(1) Foreign exchange loss on repatriation of funds from subsidiary(1) Stock-based compensation(1) ADJUSTED NET INCOME FOR THE YEAR(1) (1) A non-GAAP measure Expressed in $ millions Years ended December 31, 2010 12.96 $ $ (1.33) 2.10 (2.44) 11.29 $ $ 2009 0.62 1.75 - - 2.37 Cash generated by operating activities before changes in working capital (a non-GAAP measure) for the year totalled $22.11 million, up from $15.91 million in 2009. San Jose Mine Construction Construction activities for the San Jose Project commenced in the second quarter of 2010 and are on schedule for completion and commissioning of the mine in the third quarter of 2011 at an initial annual production rate of 1,000 tpd yielding 1.8 million oz silver and 16,000 oz gold. To the end of January 2011, $29.1 million had been invested in construction or 52% of CAPEX. Corporate Highlights 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”. In 2010, the Company entered into a credit agreement with the Bank of Nova Scotia for a $20 million senior secured revolving credit facility to be refinanced or repaid before December 2012. On March 3, 2010, the Company closed a bought-deal public offering for total gross proceeds of CAD$34.5 million. The Company issued 15,007,500 shares at a price of CAD$2.30 per share. On December 23, 2010, the Company closed a second bought-deal public offering for total gross proceeds of CAD$46 million. The Company issued 11,500,000 shares at a price of CAD$4.00 per share. On June 2010, the Company appointed Mr. Cesar Pera as Vice President of Human Resources. On July 2010, the Company announced changes to the Board of Directors with the appointment of Mr. Robert Gilmore and the resignation of Mr. Richard Clark. On August 2010, the Company announced the appointment of Mr. Jeffrey Franzen to the Board of Directors. 31  SELECTED ANNUAL INFORMATION FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated 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 Years Ended December 31, 2010 74,056 26,975 12,955 0.12 2009 51,428 6,312 623 0.01 2008 24,867 687 (910) (0.01) 243,183 139,738 115,368 3,166 1,454 1,382 In 2010, the Company generated record sales of $74.06 million compared to $51.43 million in 2009. This increase was primarily driven by higher silver prices (38%) and higher silver sales volume (15%). Total assets increased by 74% to $243.18 million with the proceeds from the $73.9 million bought- deal financings for the development of the San Jose Project. In 2009, the Company generated sales of $51.43 million compared to $24.87 million in 2008. This increase was also primarily driven by higher silver and lead head grades, in particular silver grades which increased by 64%, higher throughput, and reduced concentrate treatment charges. QUARTERLY INFORMATION The following table provides information for the eight fiscal quarters ended December 31, 2010: Expressed in $000’s, except per share data Quarters Ended Sales Mine operating income (loss) Operating income Net income (loss) Earning (loss) per share - basic - diluted 31-Dec-10 30-Sep-10 30-Jun-10 31-Mar-10 31-Dec-09 30-Sep-09 30-Jun-09 31-Mar-09 8,980 16,356 18,039 12,862 17,543 14,565 13,230 23,908 16,203 10,570 4,222 0.04 0.04 9,963 4,678 (2,542) (0.02) (0.02) 7,996 6,972 5,980 0.05 0.05 10,765 7,891 5,296 10,375 5,563 1,037 0.05 0.05 0.01 0.01 7,074 4,388 (556) (0.01) (0.01) 6,792 4,355 1,196 0.01 0.01 3,487 76 (1,054) (0.02) (0.02) The past eight quarters demonstrate a clear trend of sales growth. This trend reflects both the recovery in metal prices since the beginning of 2009 and increased silver output from the Caylloma mine. Sales and operating income in the second and third quarters of 2010 reflect a decrease in base metal prices during the period. 32 Even though the Company achieved higher sales in Q4 and Q3 2010 as compared to Q2 2010 resulted in lower net income primarily as result of the following: higher production cash cost of 13% for Q3 and 7% for Q4; stock-based compensation expense of $1.22 million and $0.76 million in Q3 and Q4 2010, respectively, compared to a recovery of $2.40 million in Q2 2010; net losses on commodity contracts of $3.18 million in Q3 2010 and $0.73 million in Q4 2010 compared to a gain of $2.90 million in Q2 2010; higher foreign exchanges losses in Q3 2010 of $1.4 million, as compared to Q2 2010 of $0.36 million; and, write off of deferred exploration costs in Q3 2010 of $0.44 million. The fourth quarter of 2010 net income of $4.22 million is primarily attributable to the record sales of $23.91 million, offset by a commodity contract loss of $0.73 million, a foreign exchange loss of $0.30 million, stock-based compensation expense of $0.76 million and bonus accrual of $0.48 million. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RESULTS OF OPERATIONS San Jose Mine Construction The Company anticipates that the San Jose Project, currently under construction in Mexico, will begin to contribute both silver and gold ounces starting in the third quarter of 2011 allowing the Company to maintain its organic silver production growth in 2011. Construction Highlights to March 23, 2011 • Processing plant construction is 33% complete. Foundation work for crushers, milling, flotation, thickening and filtering areas is complete. Mounting and installation of major plant equipment was initiated in January 2011. The 13’ x 19.5’ ball mill has been mounted where the milling section is 42% advanced. The three stage crushing circuit is being mounted and installed with a 66% advance. Flotation cells have arrived on site and thickeners are being mounted and installed. • Tailings dam construction was concluded in January 2011. • The 8MW power substation construction and commissioning has been concluded; connection to the national grid is expected in March 2011. • The mine access ramp has reached the 1,400 meter elevation, where the first production level is being developed. • Three stopes are being developed and prepared for the start of production in the third quarter at the initial rate of 1,000 tpd; Stope K is being developed on the Trinidad, Fortuna and Bonanza veins on sub-level 1430. Stopes L and M are being developed on level 1400. Overall advance on stope preparation is 115% against the program. • To December 31, 2010 the mine had built an ore stock pile of 6,816 tonnes grading 234 g/t Ag and 2.13 g/t Au. The Company anticipates an inventory of approximately 30,000 tonnes before the start of commercial operations in the third quarter of 2011. • Water pipeline installation to the mine site is 87% advanced. Processing Plant and Ancillary Facilities Construction of the 1,500 tpd processing plant and ancilliary facilities are on schedule for commissioning at an initial rate of 1,000 tpd in the third quarter of 2011. 33 The processing plant has no long lead equipment on critical path. Purchase orders for all plant equipment have been placed with equipment arriving on-site according to schedule. Processing plant construction is 33% complete. Foundation work for crushers, milling, flotation, thickening and filtering areas is complete. Mounting and installation of major plant equipment was initiated in January 2011. The 13’ x 19.5’ ball mill has been mounted where the milling section is 42% advanced. The three stage crushing circuit is being mounted and installed with a 66% advance. Flotation cells have arrived on site and thickeners are being mounted and installed. Tailings Dam Construction of the tailings dam was concluded in January 2011. The tailings dam is currently prepared to store water for the commissioning of the processing plant. The Conagua (National Water Commission of Mexico responsible for the management and preservation of national waters and their inherent goods in order to achieve sustainable use, with joint responsibility of the three tiers of government - federal, state, and municipal, and society as a whole) technical observations to the design of the tailings facility were addressed with state and federal Conagua authorities. The Company expects approval of the final Conagua permit in the coming weeks. RESULTS OF OPERATIONS (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated Underground Mine Development In December, the main access ramp reached the 1400 meter elevation -the first production level- allowing for the development of production stopes K, L and M for start-up of production at an initial mining rate of 1,000 tpd. Vein widths and grades for the Trinidad, Fortuna and Bonanza veins intersect on level 1400 and sublevel 1430 are in line with the geologic resource model. Water Sourcing The Ocotlan grey water treatment plant is fully operational and the quality of the water obtained is within design parameters. The pipeline to carry water from the grey water treatment plant to the Project site is 87% complete. Negotiations with a neighboring community are taking place to install the remaining two kilometers of the pipeline. Inflow to the process from the grey water treatment facility is required twenty months after the start of commercial operations. Power Substation Construction of the transformer and switching stations has been completed. Commissioning has been concluded and connection to the national power grid is expected during March, 2011. Caylloma Ag-Pb-Zn Mine Caylloma Mine Production Tonnes milled Average tons milled per day Silver* Grade (g/t) Recovery %* Production (Oz)* Lead Grade (%) Recovery % Production (000’s lb) Zinc Grade (%) Recovery % Production (000’s lb) Copper Production (000’s lb) Unit Costs Production cash cost (US$/oz ag)** Production cash cost (US$/tonne) Unit Net Smelter Return (US$/tonne) * Silver in lead and copper concentrates ** Net of by-product credits Years ended December 31, 2009 395,560 1,121 2010 434,656 1,231 159.24 85.67 1,906,423 154.76 85.40 1,682,546 2.44 91.28 21,373 3.10 87.99 26,137 1,026 (7.73) 51.20 163.59 3.10 93.02 25,137 3.66 89.07 28,442 190 (4.86) 46.27 124.07 34 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RESULTS OF OPERATIONS (continued) Silver production of 1,906,423 ounces, a 13% increase over the 1,682,546 ounces in 2009, exceeded 2010 guidance by 12%. This increase is attributable to an increase in mill throughput of 10%, an increase in silver recoveries of 0.3% and a 3% increase in silver head grade. Cash cost per payable ounce silver in 2010 was negative $7.73 net of by-product credits compared to negative $4.86 in 2009. The change was attributable to an increased revenue from by-product credits and increased payable silver ounces of 38% and 16%, respectively, offset by an 11% increase in refining charges. See page 12 for reconciliation of cash production cost to the cost of sales. The mill treated 434,656 tonnes of ore in 2010, compared to 395,560 tonnes in the prior year. The cash cost per tonne was $51.20 compared to $46.27 in 2009. Cash cost is a non-GAAP measure, see page 12 for reconciliation of cash cost to the cost of sales. Zinc and lead production during 2010 decreased by 8% and 15%, respectively, compared to 2009. This decrease was related to a shift in the mine plan designed to replace the polymetallic ore from the Animas vein with higher grade silver ore from level 6 in the upper part of Animas vein. The mine plan shift was made because of lower than expected grades from the Bateas silver vein which lead to an acceleration of the incorporation of level 6 into the production plan. Cash cost per tonne of treated ore for the year 2010 increased by 11% to $51.20 compared to 2009. The cost variation reflected a 2010 upward revision of underground mine contractor tariffs and labor costs directed towards reducing personnel rotation at operations, higher preparation and breakage costs at the mine, commencement of ore control drilling in 2010, local currency appreciation and preventive equipment maintenance plans that have been successful in increasing plant availability by 3% to 4%. In 2010, 71% (2009: 85%) ore was sourced from the central and lower levels of Animas vein, 17% from level 6 in the upper part of Animas vein, and 11% (2009: 15%) from Bateas, Soledad, and Silvia veins. Total mine development and preparation in 2010 was 12,110 meters, 56% in the Animas vein and 44% in the high-grade silver veins. The main focus of development in Animas vein was to extend mineralization along-strike towards the northeast on levels 10 and 12, and preparation of resource blocks between level 10 and level 12 with infrastructure as the mine plan extends below level 10 in 2011. In the upper part of Animas development and preparation was focused on incorporating level 6 into the production plan. In the high grade Soledad and Silvia silver veins mine development and preparation was aimed mainly below current working levels. In the high-grade Bateas vein exploration and development drifting focused on extending mineralization along-strike to the east and resulted in the discovery of high-grade silver ore shoots on levels 10 and 12 as reported in the press release of December 15, 2010. The main capital projects executed in 2010 were a tailings reclassification plant for $0.48 million, and the finalization of the feasibility study for the new tailings dam facility with an estimated total cost of $4.2 million. The tailings reclassification plant will allow an increase in the percentage of tailings available for backfill material and the first stage of the new tailings dam will provide 7.5 years of life at current production levels. In January 2011 production of copper-silver concentrate was discontinued at Caylloma due to a material deterioration in commercial treatment terms with respect to 2010. The Company is monitoring market conditions to evaluate restarting the circuit. Copper accounted for 4% of sales in 2010 (2009: 1%). 35 RESULTS OF OPERATIONS (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated Caylloma Mine Concentrates Years ended December 31, 2009 2010 Zinc Opening Inventory (t) Production (t) Sales (t) Adjustment (t) Closing Inventory (t) Ag in concentrate (g/t) Zn in concentrate (%) Lead Opening Inventory (t) Production (t) Sales (t) Adjustment (t) Closing Inventory (t) Ag in concentrate (g/t) Pb in concentrate (%) Copper Opening Inventory (t) Production (t) Sales (t) Adjustment (t) Closing Inventory (t) Ag in concentrate (g/t) Cu in concentrate (%) Financial Results 369 22,291 22,419 22 263 96 53 408 15,015 15,250 14 188 1,499 65 46 2,085 2,117 15 29 17,644 22 295 23,700 23,563 (63) 369 95 54 17 18,078 17,715 28 408 2,567 63 0 411 366 1 46 14,496 21 During the year ended December 31, 2010 the Company generated net income of $12.96 million (2009: $0.62 million) on operating income of $30.11 million (2009: $14.38 million). Sales for the year were $74.06 million (2009: $51.43 million). Increased sales were partially offset in operating income by a higher cash cost per tonne of $51.20 (2009: $46.27). Operating income also includes higher corporate selling, general and administrative expenses of $5.23 million compared to 2009. These expenses were associated with the growth of the Company, legal fees related to the credit facility, development of corporate projects and bonus payments. 36 Net income includes commodity contracts gain of $0.74 million (2009: loss $7.36 million), foreign exchange loss of $2.70 million (2009: $0.65 million), and stock-based compensation recovery of $0.42 million (2009: expense $2.71 million). Sales increased by 44% to $74.06 million (2009: $51.43 million) compared to a year ago. The increase is primarily attributable to higher silver prices (38%) and higher sales volume (15%). Zinc and lead metal sold were below last year (7% and 11%, respectively) with zinc and lead prices above last year (31% and 25%, respectively). RESULTS OF OPERATIONS (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated Caylloma Mine Metal Sold and Prices Years ended December 31, 2010 2009 Silver Sales (Oz)* Realized Price (US$/Oz)** Average Price (US$/Oz) Lead Sales (000’s lb)* Realized Price (US$/lb)** Average Price (US$/lb) Zinc Sales (000’s lb)* Realized Price (US$/lb)** Average Price (US$/lb) Copper Sales (000’s lb)* Realized Price (US$/lb)** Average Price (US$/lb) Gold Sales (Oz)* Realized Price (US$/Oz)** Average Price (US$/Oz) 1,894,703 19.05 20.16 21,461 0.80 0.97 26,306 0.60 0.98 1,021 2.67 3.42 2,411 939.45 1,225.07 1,645,629 13.75 14.65 24,184 0.61 0.78 28,175 0.42 0.73 163 1.59 2.34 2,397 812.08 972.98 37 * The current and subsequent period may include final settlement quantity adjustments from prior periods. ** Considers deductions, treatment, and refining charges as applicable. Treatment charges are allocated to the base metals. Cost of sales increased by 25% to $22.27 million (2009: $17.76 million) compared to last year. The increase is primarily attributable to an 11% higher unit production cash costs and increased throughput of 10%. Refer to Page 7 discussion on cash cost per tonne of treated ore. Operating income increased by 109% to $30.11 million (2009: $14.38 million) compared to 2009. The increase is primarily attributable to higher sales, a 115% decrease in stock-based compensation, a 59% decrease in write-off of deferred exploration costs and a 15% increase in depletion, depreciation and accretion. These savings were offset by a 25% increase in cost of sales, and a 55% increase in selling, general and administrative expenses. Selling, general and administrative expenses increased by 55%, in 2010, to $14.79 million (2009: $9.56 million). The increase is primarily attributable to corporate general and administrative expenses associated with the growth of the Company, legal fees related to the credit facility with the Bank of Nova Scotia and bonus payments. Corporate general and administrative expenses Peruvian subsidiary: general and administrative expenses selling expense (including trucking of concentrate) government royalty Expressed in $ millions Years ended December 31, 2010 8.32 $ $ $ $ $ 2.99 2.69 0.79 6.47 14.79 $ $ $ 2009 4.06 3.08 1.93 0.49 5.50 9.56 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RESULTS OF OPERATIONS (continued) Stock-based compensation recovery of $0.42 million (2009: expense $2.71 million) is primarily attributable to the cancellation of 2,665,000 share purchase options as shareholder approval was not obtained at the Company’s annual general meeting held on June 23, 2010 resulting in a stock-based compensation recovery of $2.44 million. In addition, stock-based compensation is impacted by the mark-to-market value of the Company’s deferred and restricted share units of $2.02 million (2009: $nil). Interest and other (expenses) income decreased by 188% to an expense of $0.38 million (2009: income $0.43 million) compared to a year ago. The increase in costs is primarily attributable to the dividend withholding tax paid of $0.27 million (2009: $nil) offset by an increase in interest income arising from higher interest rates applied to higher cash and cash equivalents and short term investments balances. Interest and finance expenses, increased by 240% to $0.54 million (2009: $0.16 million) compared to a year ago. The increase is primarily attributable to the commitment and standby fees associated with the Bank of Nova Scotia credit facility and capital lease obligations at our operating subsidiary. Net gain (loss) on commodity contract increased to a net gain of $0.74 million (2009: loss ($7.36 million)). The gain reflected 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 $0.74 million gain is a mark-to-market effect of $2.12 million ($1.33 million, net of tax), related to open contracts as at December 31, 2010 expiring March 2011. The Company occasionally enters into commodity forward and option contracts to secure a minimum price level on part of Caylloma’s zinc and lead metal production. Additionally, for the unhedged balance of production, the Company enters regularly into short term forward lead and zinc and silver option contracts 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. Price protection program - Derivatives As at December 31, 2010, the Company had the following contracts outstanding: Type of contract Forward sale Forward sale Long put Short call Long put Short call Metal Lead Zinc Silver Silver Silver Silver Total tonnage (t) or ounces (oz) 210 t 240 t 90,000 oz 90,000 oz 50,000 oz 50,000 oz Settlement period March 2011 March 2011 January 2011 January 2011 January 2011 January 2011 Price/t or Price/oz $2,500/t $2,415/t $28.00/oz $32.10/oz $29.00/oz $31.70/oz 38 Foreign exchange loss, increased four-fold to $2.70 million (2009: $0.65 million). The increase is primarily attributable to the $2.10 million foreign exchange loss realized upon the repatriation of funds from the Company’s Peruvian subsidiary. Income tax provision increased by 139% to $14.02 million (2009: $5.87 million). Income tax provision is comprised of current and future income tax expense. Current income tax for the period, including the worker profit sharing plan regulated by Peruvian law, totalled $10.94 million (2009: $5.08 million). Future income tax expense, amounting to $3.08 million (2009: $0.79 million) was 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, 2010 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. 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 companies. 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, 2010 and 2009. Cost of sales Add / (Subtract) Change in concentrate inventory Inventory adjustment Depletion, depreciation, and accretion Cash cost $’000’s Years ended December 31, 2009 23,699 2010 29,129 (305) 290 (6,859) 22,255 549 - (5,944) 18,304 Total processed ore (tonnes) 434,656 395,561 Cash cost per tonne of processed ore ($/t) Cash cost Add / (Subtract) By-product credits1 Refining charges Cash cost applicable per payable ounce 51.20 22,255 (37,825) 1,576 (13,994) 46.27 18,304 (27,318) 1,416 (7,598) Payable silver ounces 1,811,102 1,563,775 39 Cash cost per ounce of payable silver ($/oz) (7.73) (4.86) 1 By-product credits as included in the provisional liquidation LIQUIDITY AND CAPITAL RESOURCES The Company’s cash and cash equivalents as at December 31, 2010 totalled $70.30 million, and short term investments totalled $20.51 million. Working capital amounted to $97.09 million. During 2010, cash generated by operating activities before changes in working capital was $22.19 million. Changes in working capital amounted to $1.08 million, resulting in cash generated by operating activities of $21.11 million. During 2010, cash consumed by the Company in investing activities totalled $57.39 million with $16.60 million for mineral properties, $19.82 million for property, plant and equipment, $4.29 million for deposits on long term assets, and short term investments of $13.86 million. The total investment in San Jose amounted to $27.90 million and included $8.12 million for mineral properties, $15.39 million for property, plant and equipment, and $4.39 million for deposits on long term assets. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated LIQUIDITY AND CAPITAL RESOURCES (continued) During 2010, cash generated by financing activities totalled $73.69 million comprised of net proceeds on the issuance of common shares of $74.92 million less the repayment of capital lease obligations of $1.23 million. In 2010, the Company entered into a credit agreement with the Bank of Nova Scotia for a $20 million senior secured revolving credit facility (“credit facility”) to be refinanced or repaid on or within two and one-half years or before December 2012. The credit facility is secured by a first ranking lien on Bateas and its assets and bears interest and fees at prevailing market rates. No funds were drawn from this credit facility during the year. The Company has raised funds from two prospectus financings. The details of the expected use of proceeds and actual use of proceeds are discussed below. Prospectus February 18, 2010 Closed March 2, 2010 San Jose Project Financing Expressed in CAD $ millions Actual Use of Proceeds** 3.3 $ 4.8 3.9 2.4 2.2 1.0 17.6 $ Variance 3.4 11.8 (2.0) 0.6 (2.2) (1.0) 10.6 $ $ $ Expected Use of Proceeds* 6.7 16.6 1.9 3.0 - - 28.2 $ Mine development Processing plant Tailings dam Water and Infrastructure Energy supply Construction management Total *excludes over-allotment **US CAD FX rate at 1.0 Prospectus December 17, 2010 Closed December 23, 2010 San Jose Project Financing** Expressed in CAD $ millions Expected Use of Proceeds* 14.5 5.5 17.7 $ $ 37.7 Planned expansion Exploration programs Working capital Water and Infrastructure Energy supply Construction management Total *excludes over-allotment ** funds to be utilized post development $ Actual Use of Proceeds - - - - - - - $ Variance 14.5 5.5 17.7 - - - 37.7 $ $ 40 Management believes the Company’s cash position, along with its ongoing operation in Caylloma and the credit facility, is sufficient to support the Company’s operating and capital requirements on an ongoing basis. Actual funding 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 it recognizes the uncertainty attached thereto.  LIQUIDITY AND CAPITAL RESOURCES (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated Guarantees and Indemnifications (expressed in $’000’s) 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 obligations 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 Caylloma mine closure plan was approved in November 2009 with total closure costs of $3,587 of which $1,756 is subject to an 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 estimated 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 $293. This bank letter of guarantee expires 360 days from December 2010. Banco Bilbao Vizcaya Argentaria, S.A., has also established bank letters of guarantee totalling $54 to provide an annual guarantee associated with an office lease contract and truck rentals. These bank letters of guarantee expire 360 days from June 2010. Interbank, a third party, has renewed the bank letter of guarantee in the amount of $2, in favor of the Peruvian Ministry of Energy and Mines, to allow a temporary concession to study electric power generation in the hydro electric power plant, to expire April 2011. 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, 2010, these obligations amounted to $711 with $231 and $480 maturing in 2011 and 2012, respectively. 41 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 expenditures, 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. RELATED PARTY TRANSACTIONS The Company incurred charges from directors, officers, and companies having a common director or officer as follows: (Expressed in $’000’S) Transactions with related parties Consulting fees 1 Salaries and wages 2,3 Other general and administrative expenses 3 Expressed in $’000’s Years ended December 31, 2010 175 174 185 534 $ $ $ $ 2009 145 122 159 426 1Consulting 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. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RELATED PARTY TRANSACTIONS (EXPRESSED IN $’000’S) (continued) 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. Amounts due to/(from) related parties are comprised of the following: 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, 2010 $ $ $ (1) $ $ 41 $ 40 December 31, 2009 (1) 50 49 4Owing from a director includes non-interest bearing advances to Jorge A. Ganoza Durant at December 31, 2010 and 2009. 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 financial 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. The estimate of mineral reserves is prepared by Qualified Persons in accordance with industry standards 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 depletion of this asset. 42 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. CRITICAL ACCOUNTING ESTIMATES (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated 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 potential, 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. Stock-based Compensation i. Stock Option Plan 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. ii. Deferred Share Unit Plan (“DSU”) The Company’s DSU compensation liability is accounted for based on the number of units outstanding and the market value of the Company’s common shares at the balance sheet date. The year-over-year change in the deferred share unit compensation liability is recognized in operating income. iii. Restricted Share Unit Plan (“RSU”) The Company recognizes a compensation cost in operating income on a prescribed vesting basis for each RSU granted equal to the market value of the Company’s common shares at the date of which RSUs are awarded to each participant prorated over the performance period and adjusts for changes in the market value until the end of the performance date. The cumulative effect of the change in market value is recognized in operating income in the period of change. 43 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated FINANCIAL INSTRUMENTS AND RELATED RISKS 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 carrying value of cash and cash equivalents, short term investments, accounts receivable, accounts payable and accrued liabilities, and due to related parties 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 uncertainties and matters of significant judgement and, therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The analysis of financial instruments that are measured subsequent to initial recognition at fair value can be categorized into Levels 1 to 3 based upon the degree to which the fair value is observable. • 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 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. Cash and cash equivalents Short term investments Accounts receivable Derivatives Financial assets (liabilities) at fair value as at December 31, 2010 Level 1 70,298 20,509 - - 90,807 $ $ Level 2 - - 12,551 (133) 12,418 $ - $ $ $ Level 3 - $ - - - $ There were no changes in the levels during the year ended December 31, 2010. Cash and cash equivalents Short term investments Accounts receivable Derivatives Financial assets (liabilities) at fair value as at December 31, 2009 Level 1 30,763 6,034 - - 36,797 $ $ Level 2 - - 8,322 (3,055) 5,267 $ $ Level 3 - - - - - $ $ $ $ Total 70,298 20,509 12,551 (133) 103,225 Total 30,763 6,034 8,322 (3,055) 42,064 44 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated FINANCIAL INSTRUMENTS AND RELATED RISKS (continued) 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 to 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 counterparties the Company believes to be creditworthy. During the year ended December 31, 2010, there have been no changes in the classification of financial assets and liabilities in level 3 of the hierarchy. (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, 2010, 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): Expressed in ‘000’s December 31, 2010 December 31, 2009 45 Cash and cash equivalents Short term investments Accounts receivable Long term investment and receivable Accounts payable and accrued liabilities Long term liability Asset retirement obligation $ 54,782 S/. 20,514 71 - (625) (1,999) - - 1,304 - (27,268) - (9,169) Canadian Dollars Nuevo Soles 741 $ Mexican Pesos Canadian Dollars 2,201 $ 21,283 560 5 - (194) - - - 42,452 24,209 (6,390) - (19,959) S/. Nuevo Soles 302 - 880 - (17,150) - (8,835) Mexican Pesos $ 1,283 - 6,565 - (623) - - Based on the above net exposure as at December 31, 2010, 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 Impact to net income (loss) $ 8,081 $ (1,360) $ 382 FINANCIAL INSTRUMENTS AND RELATED RISKS (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated (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 and 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, 2010, the Company has a Mexican value added tax of $3.34 million and Peruvian value added tax of $0.14 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 investments, and its committed liabilities. The Company expects the following maturities of its financial liabilities (including interest), operating leases, and other contractual commitments: Expressed in $‘000’s Expected payments due by period as at December 31, 2010 Accounts payable and accrued liabilities Due to related parties, net Derivatives Long term liability Total1 $ $ Less than 1 year 13,496 $ 40 133 1,083 14,752 $ 1-3 years 4-5 years After 5 years - $ - - 3,243 3,243 $ - $ - - - - $ - $ - - - - $ Total 13,496 40 133 4,326 17,995 46 1 Amounts above do not include payments related to the following: (i) the Company’s anticipated asset retirement obligation of $4,924 associated with mine closure, land reclamation, and other environmental matters. (e) Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The risk that the Company will realize a loss as a result of a decline in the fair value is limited because the balances are generally held with major financial institutions in demand deposit accounts. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated (f) Metal price risk The Company is exposed to metals price risk with respect to silver, gold, zinc, lead, and copper sold through its mineral concentrate products. The Company mitigates this risk by implementing price protection programs for some of its zinc and lead production through the use of derivative instruments. As a matter of policy, the Company does not hedge its silver production. FINANCIAL INSTRUMENTS AND RELATED RISKS (continued) OTHER DATA Additional information related to the Company is available for viewing at www.sedar.com and the Company’s website at www.fortunasilver.com. The Company’s outstanding share position as at March 23, 2011 is 122,749,221 common shares. In addition, a total of 4,305,500 incentive stock options are currently outstanding as follows: SHARE POSITION AND OUTSTANDING WARRANTS AND OPTIONS Type of Security No. of Shares Incentive Stock Options: 47 TOTAL OUTSTANDING OPTIONS 240,000 200,000 60,000 200,000 7,500 225,000 825,000 225,000 60,000 670,000 20,000 38,000 5,000 25,000 250,000 810,000 240,000 205,000 4,305,500 Exercise Price (CAD$) $1.35 $2.29 $1.75 $1.75 $0.85 $1.55 $1.66 $1.61 $0.85 $2.22 $0.85 $0.85 $0.85 $0.85 $2.52 $0.85 $0.85 $0.83 Expiry Date 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 June 27, 2017 July 2, 2017 October 24, 2017 February 5, 2018 October 5, 2018 November 5, 2018 July 6, 2019 CHANGE IN ACCOUNTING POLICY Adoption of New Accounting Standards The Company has not adopted any new accounting standards during the year. RECENTLY RELEASED CANADIAN ACCOUNTING STANDARDS FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated The Company has assessed new and revised accounting pronouncements that have been issued and determined that the following will 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. 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. IFRS Project Overview The Company continues to advance through its IFRS transition project plan. During 2009, the Company began planning its transition to IFRS. The process consists of three phases: Scoping and Diagnostics, Analysis and Development, and Implementation and Review. Phase One: Scoping and Diagnostics, which involved project planning and identification of differences between current Canadian GAAP and IFRS, was completed in the third quarter of 2009 with the assistance of external advisors. The resulting identified areas of accounting difference of highest potential impact to the Company, were: IFRS 1 “First-time Adoption of IFRS”; International Accounting Standard (“IAS”) 21 “The Effects of Changes in Foreign Exchange Rates”; and, IAS 16 “Property, Plant and Equipment”. Phase Two: Analysis and Development involved detailed diagnostics and evaluation of the financial impacts of various options and alternative methodologies provided for under IFRS: identification and design of operational and financial processes; initial staff training; analysis of IFRS 1 optional exemptions and mandatory exceptions to the general requirement for full retrospective application upon transition to IFRS; summarization of 2011 IFRS disclosure requirements; and development of required solutions to address identified issues. 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 included the identification of IFRS - Canadian GAAP differences, accounting policy considerations, and preliminary implementation plans. The high impact areas relating to conversion include foreign currency; property, plant and equipment; income taxes; and provisions, contingent liabilities and contingent assets (including asset retirement obligations). During the second quarter of 2010, the technical review aspects of these assessments were substantially completed. During the third and fourth quarters of 2010, the Company substantially completed the preliminary opening balance sheet quantification of the identified technical differences and quantification of the impacts of IFRS transition on the first three quarters of 2010. 48 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RECENTLY RELEASED CANADIAN ACCOUNTING STANDARDS (continued) Phase Three: Implementation and Review, will involve the execution of changes to information systems and business processes; completion of formal authorization processes to approve recommended accounting policy changes; integration of appropriate changes to maintain the integrity of internal controls over financial reporting and disclosure controls and procedures; and further training programs across the Company’s finance and other affected areas, as necessary. It will culminate in the collection of financial information necessary to compile IFRS-compliant financial statements and reconciliations; embedding of IFRS in business processes; and, audit committee approval of IFRS-compliant financial statements. This phase commenced in the third 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. Changes in circumstances may cause the Company to revise its IFRS opening balance sheet and policy choices before the changeover date. The opening balance sheet will be published in the first quarter of 2011. First Time Adoption Elections and Accounting Policy Changes At the present time the Company is planning to apply five of the 17 elections within IFRS 1 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. IFRS 2 “Share-based Payment” 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. IAS 21 “The Effects of Changes in Foreign Exchange Rates” which allows for the cumulative translation differences that existed at the date of transition to IFRS to be reset to zero. IAS 23 “Borrowing Costs” which allows full retrospective application to be avoided by electing an effective date as the date of transition, January 1, 2010, to IFRS. IAS 37 “Provisions, Contingent Liabilities and Contingent Assets” which allows a short cut method in recalculating both the decommissioning liability and asset at the transition date of January 1, 2010. This avoids the requirement to recalculate the liability retrospectively from the date of recognition and then re-measure it at each subsequent reporting period up until the date of transition. 49 Below is a preliminary summary of the impacts of the high impact areas relating to conversion to IFRS and their expected impact on the Company: a) Foreign Currency Under 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 currency under IFRS will need to translate their balance sheets to the functional currency at the transition date. The Company’s preliminary analysis determined that Compania Minera Cuzcatlan S.A. de C.V., Fortuna Silver Mines Peru S.A.C., and Recursos del Golfo, S.A. change from a Canadian dollar (“CAD$”) measurement currency under Canadian GAAP to a United States dollar (“US$”) functional currency under IFRS. FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RECENTLY RELEASED CANADIAN ACCOUNTING STANDARDS (continued) The Company intends to continue with a US$ presentation currency under IFRS. The Company is planning to take the IFRS 1 exemption that resets the cumulative translation adjustment balance (“CTA”) to zero, to reduce the conversion effort. This will result in the reclassification of the CTA existing balance into deficit on transition to IFRS on January 1, 2010, in the preliminary amount of $2.90 million. The preliminary adjustments for the opening balance sheet includes a foreign currency reduction to property, plant and equipment and mineral properties of $0.33 million and $2.20 million, respectively. 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 component 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 has completed a detailed review of fixed assets and preliminarily concluded that there will be no transitional adjustments as a result of this issue. Under IFRS, there is an option to use either the cost method or the revaluation model for subsequent measurement of classes of property, plant and equipment. The Company plans to continue to use the cost method. 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. The Company has elected to apply the borrowing cost requirements effective January 1, 2010. 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. The Company has preliminarily concluded that there will be no impairment adjustments required at the transition date to IFRS. c) Income Taxes Under Canadian GAAP, current and future income tax assets and liabilities are referred to as “future income tax” (“FIT”) assets or liabilities whereas under IFRS the terminology is “deferred tax”. There are no accounting policy choices available upon transition to IAS 12 “Income Taxes”. 50 RECENTLY RELEASED CANADIAN ACCOUNTING STANDARDS (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated The preliminary analysis completed to date has identified two significant differences in the area of accounting 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. 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 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 volatility in the tax expense as foreign exchange changes will have a more pervasive impact on tax expense. IAS 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, where assets are acquired other than in a business combination and a temporary difference arises the associated FIT asset (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. In addition, IFRS requires additional disclosure with respect to “outside basis” differences not recognized in the tax provision. These “outside basis” differences are essentially any tax liability that would result on accounts that are eliminated upon consolidation (for example: intercompany loans, intercompany dividends, or investments). The Company has some outside basis differences arising from foreign exchange rates on loans denominated in United States dollars. The preliminary adjustment to the future income tax liability opening balance sheet amounts to a reduction of $5.38 million comprised of the following: reversal of future income tax of $1.09 million related to workers’ participation; $3.47 million related to temporary differences on business combinations; $0.15 million related to provision; and, $0.67 million related to foreign currency adjustments. d) Provisions, Contingent Liabilities and Contingent Assets (including asset retirement obligations) Under Canadian GAAP, the Company recognizes decommissioning liabilities where there is a legal obligation as compared to IFRS requiring including both legal and constructive obligations. The preliminary analysis has determined there are no additional constructive obligations for the Caylloma mine or the San Jose Project. Under Canadian GAAP, the Company applies a credit adjusted risk free interest rate to the undiscounted cash flow estimate at each site. IFRS requires the Company to use a pre-tax discount rate, typically a long term government bond rate in the jurisdiction the Company intends to raise the financing to meet the reclamation costs. In addition, under Canadian GAAP, the estimate of cash flows is based on a third party concept and cannot be based on the Company’s calculated cost of using its own equipment. IFRS allows a Company to use internal cost estimates if the Company is likely to use its own machinery and labour to perform the reclamation work. 51 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated RECENTLY RELEASED CANADIAN ACCOUNTING STANDARDS (continued) The Company has elected to take the IFRS 1 exemption to avoid the requirement to recalculate the liability retrospectively from the date of recognition and then re-measure it at each subsequent reporting period up until the date of transition. On a go forward basis, the Company will be required to present accretion as a finance cost under IFRS. In addition, there will be differences due to the subsequent re-measurement of the decommissioning liability. The preliminary adjustment to the asset retirement obligation opening balance sheet amounts to an increase of $0.39 million. e) Other The Company considered both IFRS 2 - “Share-based Payment” and IFRS 6 - “Exploration for and Evaluation of Mineral Resources” as part of its initial diagnostic assessment. The Company has concluded that there will be no significant or material transitional adjustments or changes in reported results arising from the application of these standards upon transition to IFRS. OUTLOOK ON FUTURE EARNINGS Future net earnings will be impacted by the change in the accounting methodology of recognizing deferred taxes that arise on foreign non-monetary assets or liabilities. The result of this calculation difference will be added volatility in the tax expense as foreign exchange swings will have an impact on the tax expense. QUANTITATIVE IMPACT ON TRANSITION TO IFRS Based on the analysis completed to date, the Company expects the following impact on shareholders equity on transition to IFRS: Shareholders’ Equity, Canadian GAAP, December 31, 2009 Adjustments: Effect of foreign exchange on property, plant and equipment Deferred income tax adjustments Transfer of accumulated other comprehensive income to deficit Reset accumulated other comprehensive income to zero Asset retirement obligation adjustments Shareholders’ Equity, IFRS, January 1, 2010 Expressed in $ millions $ 112.56 (2.54) 1.48 2.90 (2.90) (0.32) 111.18 $ Internal Control over Financial Reporting and Disclosure Controls and Procedures The Company has considered the short term effects the IFRS transition will have on our internal controls over financial reporting and disclosure controls and procedures. We will continue to monitor and assess these controls on an on-going basis. Business Activities and Key Performance Measures The Company has considered what effects the IFRS transition will have on our business policies and activities. The following key areas are likely to be affected: • • Dual reporting obligation for the year 2010 because statements are required under both Canadian Internal controls over financial reporting with respect to the IFRS transition project; GAAP and IFRS for that year; • Budgeting and Forecasting activities during the IFRS transition year, 2010. The budgeting process for 2011 factored in IFRS related impacts that have been identified; and, • Key performance measures. 52 QUANTITATIVE IMPACT ON TRANSITION TO IFRS (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated Financial Reporting Expertise in IFRS The Company is maintaining its financial reporting expertise and competencies by addressing training requirements through IFRS sessions provided by external advisors. The training is targeted to key finance staff and will continue to be delivered in 2011. IT Systems The extent of the impact of the Company’s information systems for transitioning to IFRS has been determined. The adoption of IFRS will have an impact on the Company’s information systems in particular the process of consolidating information for reporting of the external financial statements. The Company has commenced a process of changing its consolidation. During the third quarter, the Company engaged a third party to assist with implementing modifications to ensure an efficient conversion to IFRS. OTHER RISKS AND UNCERTAINTIES There have been no major changes from the reported risks factors outlined in the Annual Information Form dated March 31, 2010. 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, 2010, 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 accordance 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 establishing 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 statements in accordance with Canadian generally accepted accounting principles. The Company’s management, including its CEO and CFO, believe that due to its inherent limitations, internal control over financial reporting may not prevent or detect misstatements on a timely basis. Also, projection of any evaluation of the effectiveness of internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate. There has been no change in the Company’s internal control over financial reporting that occurred during the period that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting. OUTLOOK The Company anticipates that the San Jose Project, currently under construction in Mexico, will begin to contribute both silver and gold ounces starting in the third quarter of 2011 allowing Fortuna to maintain its organic silver production growth in 2011. 53 FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated OUTLOOK (continued) Once San Jose is in operation in the third quarter of 2011, Management anticipates that Fortuna’s operations at Caylloma and San Jose should produce a total of 2.4 million ounces of silver and 7,530 ounces of gold or 2.8 million silver equivalent ounces (*) plus base metal credits in 2011. San Jose’s contribution will be 500,000 ounces of silver and 4,580 ounces of gold. The Company is executing plans to reach a production rate of 7 million ounces of silver equivalent annual production from existing reserves by 2013. CAUTIONARY STATEMENT ON FORWARD-LOOKING INFORMATION 2011 Production Guidance Mine Caylloma, Peru San Jose, Mexico Total : Silver (oz) 1,900,000 500,000 2,400,000 Gold (oz) 2,950 4,580 7,530 Zinc (lbs) 25,200,000 - 25,200,000 Lead (lbs) 16,600,000 - 16,600,000 Copper (lbs) 760,000 - 760,000 (*) Based on Ag = US$ 23.60/oz, Au = US$ 1,350/oz and metallurgical recoveries of 88% and 90% for Ag and Au respectively In 2012, its first full year of production, the San Jose Mine is scheduled to produce 1.77 million ounces of silver and 16,120 ounces of gold or 2.75 million silver equivalent ounces. At full design capacity, planned for late 2013 (24 months from the start of operations), the San Jose Mine’s annual production forecast is 3.2 million ounces of silver, 24,220 ounces of gold or 4.6 million silver equivalent ounces. Certain statements contained in this MD&A and any documents incorporated by reference into this MD&A constitute forward-looking statements and forward-looking information. Any statements or information that express or involve discussions with respect to predictions, expectations, beliefs, plans, projections, objectives, assumptions or future events or performance (often, but not always, using words or phrases such as “expects”, “is expected”, “anticipates”, “believes”, “plans”, “projects”, “estimates”, “assumes”, “intends”, “strategies”, “targets”, “goals”, “forecasts”, “objectives”, “budgets”, “schedules”, “potential” or variations thereof or stating that certain actions, events or results “may”, “could”, “would”, “might” or “will” be taken, occur or be achieved, or the negative of any of these terms and similar expressions) are not statements of historical fact and may be forward-looking statements or information. Forward-looking statements or information relate to, among other things: • estimates of mineral reserves and mineral resources to the extent that they involve estimates of the • mineralization that will be encountered if the property is developed; timing of the completion of construction activities at the Company’s properties and their completion on budget; • production rates at the Company’s properties; • cash cost estimates; • • • • timing to achieve full production capacity at the Company’s properties; timing for completion of infrastructure upgrades related to the Company’s properties; timing for delivery of materials and equipment for the Company’s properties; and the sufficiency of the Company’s cash position and its ability to raise equity capital or access debt facilities. Forward-looking statements are necessarily based upon a number of estimates and assumptions that, while considered reasonable by the Company as at the date of such statements, are inherently subject to significant business, economic, social, political and competitive uncertainties and contingencies and other factors that could cause actual results or events to differ materially from those projected in the forward-looking statements. The estimates and assumptions of the Company contained or incorporated by reference in this MD&A which may prove to be incorrect, include, but are not limited to, (1) that all 54 CAUTIONARY STATEMENT ON FORWARD-LOOKING INFORMATION (continued) FORTUNA SILVER MINES INC. MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2010 Dollar amounts expressed in US dollars, unless otherwise indicated required third party contractual, regulatory and governmental approvals to the Offer will be obtained for the development, construction and production of its properties, (2) there being no significant disruptions affecting operations, whether due to labour disruptions, supply disruptions, power disruptions, damage to equipment or otherwise; (3) permitting, development, expansion and power supply proceeding on a basis consistent with the Company’s current expectations; (4) currency exchange rates being approximately consistent with current levels; (5) certain price assumptions for silver, lead, zinc and copper; (6) prices for and availability of natural gas, fuel oil, electricity, parts and equipment and other key supplies remaining consistent with current levels; (7) production forecasts meeting expectations; (8) the accuracy of the Company’s current mineral resource and reserve estimates; (9) labour and materials costs increasing on a basis consistent with the Company’s current expectations; and (10) assumptions made and judgments used in engineering and geological interpretation. In addition, there are known and unknown risk factors which could cause the Company’s actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by the forward-looking statements. Known risk factors include, risks associated with project development; the need for additional financing; operational risks associated with mining and mineral processing; changes in national and local government legislation, taxation, controls, regulations and political or economic developments in Canada, Mexico, the United States, Peru or other countries in which the Company does or may carry on business; the possibility of cost overruns or unanticipated expenses; fluctuations in silver, lead, zinc and copper prices; title matters; uncertainties and risks related to carrying on business in foreign countries; environmental liability claims and insurance; reliance on key personnel; currency exchange rate fluctuations; competition; and other risks and uncertainties, including those described in the Risks and Uncertainties section in the MD&A and in the Risk Factors section in the Company’s Annual Information Form for the financial year ended December 31, 2009 filed with the Canadian Securities Administrators and available at www.sedar.com. Although the Company has attempted to identify important factors that could cause actual actions, events or results to differ materially from those described in forward-looking statements, there may be other factors that cause actions, events or results not to be as anticipated, estimated or intended. These forward-looking statements are made as of the date of this MD&A. There can be no assurance that forward looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Accordingly, readers should not place undue reliance on forward-looking statements. 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. 55 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 INDEPENDENT AUDITOR’S REPORT To the Shareholders of Fortuna Silver Mines Inc. We have audited the accompanying consolidated financial statements of Fortuna Silver Mines Inc., which comprise the consolidated balance sheets as at December 31, 2010 and 2009, and the consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for the years then ended, and a summary of significant accounting policies and other explanatory information. Management’s Responsibility for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with Canadian generally accepted accounting principles, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Fortuna Silver Mines Inc. as at December 31, 2010 and 2009 and the results of its operations and cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants Vancouver, British Columbia March 23, 2011 56 CONSOLIDATED BALANCE SHEETS FORTUNA SILVER MINES INC. CONSOLIDATED BALANCE SHEETS AS AT DECEMBER 31, Expressed in thousands of US Dollars ASSETS CURRENT Cash and cash equivalents Short term investments Accounts receivable and prepaid expenses GST/HST and value added tax receivables Inventories DEPOSITS ON LONG TERM ASSETS PROPERTY, PLANT AND EQUIPMENT MINERAL PROPERTIES LIABILITIES CURRENT Accounts payable and accrued liabilities Due to related parties Derivatives Current portion of long term liability LONG TERM LIABILITY ASSET RETIREMENT OBLIGATION FUTURE INCOME TAX LIABILITY SHAREHOLDERS’ EQUITY SHARE CAPITAL CONTRIBUTED SURPLUS RETAINED EARNINGS (DEFICIT) ACCUMULATED OTHER COMPREHENSIVE INCOME Notes 2010 4 6 7 8 9 10 11 12 5 13 a) 13 14 15 $ $ $ $ 70,298 20,509 13,454 3,542 4,034 111,837 4,533 35,763 91,050 243,183 13,496 40 133 1,083 14,752 3,166 4,924 14,333 37,175 180,403 11,116 3,597 10,892 14,489 206,008 243,183 2009 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 27,181 104,701 14,315 (9,357) 2,898 (6,459) 112,557 139,738 $ $ $ $ 57 COMMITMENTS AND CONTINGENCIES SUBSEQUENT EVENT 18 22 APPROVED BY THE DIRECTORS: “Jorge Ganoza Durant” , Director “Robert R. Gilmore” , Director Jorge Ganoza Durant Robert R. Gilmore The accompanying notes are an integral part of these audited consolidated financial statements 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 CONSOLIDATED STATEMENTS OF OPERATIONS Sales Cost of sales Depletion, depreciation and accretion MINE OPERATING INCOME Notes $ Selling, general and administrative expenses Stock-based compensation (recovery) expense Write-off of deferred exploration costs 12 16 c) OPERATING INCOME Interest and other (expenses) income Interest and finance (expenses) Net gain (loss) on commodity contracts (Loss) on disposal of property, plant and equipment (Loss) on disposal of mineral property (Loss) on disposal of investment Foreign exchange (loss) INCOME BEFORE INCOME TAXES AND NON-CONTROLLING INTEREST Income tax provision Non-controlling interest NET INCOME FOR THE YEAR 15 $ 2010 74,056 22,270 6,859 44,927 14,789 (416) 443 14,816 30,111 (379) (544) 736 (27) (100) (119) (2,703) (3,136) 26,975 14,020 - 12,955 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 $ $ Earnings per Share - Basic Earnings per Share - Diluted Weighted average number of shares outstanding - Basic Weighted average number of shares outstanding - Diluted 0.12 $ 0.12 $ 108,120,452 110,564,767 0.01 $ $ 0.01 91,802,881 91,802,881 58 The accompanying notes are an integral part of these audited consolidated financial statements FORTUNA SILVER MINES INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, Expressed in thousands of US Dollars CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Net income for the year Other comprehensive income Unrealized gain 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 Transfer of unrealized loss to realized loss upon reduction of net investment, net of taxes Unrealized gain on translation of functional currency to reporting currency Other comprehensive income Comprehensive income for the year 2010 12,955 $ $ - - 2,100 5,895 7,994 20,949 $ $ 2009 623 148 462 - 13,400 14,010 14,633 59 The accompanying notes are an integral part of these audited consolidated financial statements 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 for the year Items not involving cash Depletion and depreciation Accretion expense Future income tax Stock-based compensation (recovery) expense Unrealized (gain) loss on commodity contracts Non-controlling interest Write-off of deferred exploration costs Loss on disposal of equipment Loss on disposal of investments Loss on disposal of mineral property Unrealized foreign exchange loss Changes in non-cash working capital items Accounts receivable and prepaid expenses Inventories Accounts payable and accrued liabilities Due to related parties Net cash provided by operating activities INVESTING ACTIVITIES Costs relating to the acquisition of Continuum Short term investments Mineral property expenditures (Payments) receipts of value added taxes on purchase of property, plant and equipment Acquisition of property, plant and equipment Deposits on long term assets Proceeds on disposal of equipment Acquisition of long term investments Proceeds on disposal of long term investments Proceeds on disposal of mineral property Net cash used in investing activities FINANCING ACTIVITIES Net proceeds on issuance of common shares Repayment of capital lease obligations Net cash provided by financing activities INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS Effect of exchange rate changes on cash Cash and cash equivalents - beginning of year Notes 2010 $ 12,955 $ 3 6,896 185 3,080 (416) (2,922) - 443 27 119 100 1,726 22,193 (4,908) (1,537) 5,372 (11) 21,109 - (13,858) (16,595) (2,915) (19,816) (4,290) 68 - - 13 (57,393) 74,922 (1,231) 73,691 37,407 2,128 30,763 2009 623 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 (3,244) 4,553 29,454 CASH AND CASH EQUIVALENTS - END OF YEAR $ 70,298 $ 30,763 Supplemental cash flow information 21 The accompanying notes are an integral part of these audited consolidated financial statements 60 FORTUNA SILVER MINES INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY Expressed in thousands of US Dollars, except for share amounts CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY Share Capital Shares Amount Contributed Surplus Accumulated Other Comprehensive Income (Loss) (“AOCI”) Total Retained Earnings (Deficit) and AOCI Retained Earnings (Deficit) Total Shareholders’ Equity 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 ofavailable for sale long-term investment, net of taxes Unrealized gain on translation of functional currency to reporting currency Balance - December 31, 2009 Issuance of shares under bought deal financing, net of issuance costs Exercise of options Issuance of shares for property Transfer of contributed surplus on exercise of options Stock-based compensation Income for the period Transfer of unrealized loss to realized loss upon reduction of net investment, net of taxes Unrealized gain o translation of functional currency to reporting currency Balance - December 31, 2010 85,331,659 389,000 2,475,355 6,786,674 (36) $ $ 98,206 281 776 5,192 - - - - - - 246 - - - - 11,854 - - - - (246) 2,707 - - - $ (9,980) $ - - - - (11,112) $ (21,092) $ 88,968 281 776 5,192 - - - - - - - - - - - 623 - - - - - 148 - - 623 148 - 2,707 623 148 462 462 462 - 94,982,652 - $ 104,701 - 14,315 $ $ - (9,357) $ 13,400 2,898 $ 13,400 (6,459) 13,400 112,557 26,507,500 999,500 7,813 73,919 1,004 20 - - - - - - - - - - 759 - - - (759) (2,440) - - - 12,955 - - - - - - - - - - - 12,955 73,919 1,004 20 - (2,440) 12,955 - 122,497,465 - $ 180,403 - 11,116 $ $ - 3,597 $ 5,895 5,895 10,892 $ 14,489 $ 206,008 5,895 61 - - 2,100 2,100 2,100 The accompanying notes are an integral part of these audited consolidated financial statements FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 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 silver/zinc/lead/copper 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. c) Adoption of New Accounting Standards The Company has not adopted any new accounting standards during the current year. The Company is adopting International Financial Reporting Standards (“IFRS”) effective January 1, 2011. Refer to Note 2 v). 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 liabilities, 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 62 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) 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 recognition, 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 and Cash Equivalents Cash and cash equivalents which are 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, of 91 days to one year, from the date of acquisition. h) Deposits on Long Term Assets 63 Deposits on long term assets consist of advance payments to construction contractors and equipment providers and other receivables which have a maturity period of greater than one year. 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, 2010 is 9.3 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 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) in machinery 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 determine 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 expensed 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 current expenses depending on the prior treatment. 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 commissioning costs. These costs are depleted using the units-of-production method over the life of the mine, commencing on the date of commercial service. 64 l) Asset Impairment 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. 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 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, FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) 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. 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 corresponding 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, 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 ending 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. Ore stockpile and finished goods inventories are valued at the lower of production cost and net realizable value. Materials and supplies are valued at the lower of average cost and net realizable value. Production costs include all mine site costs. 65 o) Income Taxes The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, future tax assets and liabilities are recognized for the future tax consequences attributable to loss carryforwards and to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and loss carryforwards. 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. 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts p) Stock-based Compensation i. Stock Option Plan 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. ii. Deferred Share Unit Plan (“DSU”) The Company’s DSU compensation liability is accounted for based on the number of units outstanding and the market value of the Company’s common shares at the balance sheet date. The year-over-year change in the deferred share unit compensation liability is recognized in operating income. iii. Restricted Share Unit Plan (“RSU”) The Company recognizes a compensation cost in operating income on a prescribed vesting basis for each RSU granted equal to the market value of the Company’s common shares at the date of which RSUs are awarded to each participant prorated over the performance period and adjusts for changes in the market value until the end of the performance date. The cumulative effect of the change in market value is recognized in operating income in the period of change. 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. The dilutive effect of outstanding options and warrants issued should be calculated 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. 66 r) Foreign Currency Translation The Company’s functional currency is the Canadian dollar. On January 1, 2009, the Company changed its reporting currency to the US dollar. Transaction amounts denominated in foreign currencies are translated at exchange rates prevailing at the transaction dates. Carrying values of foreign currency monetary assets and liabilities are adjusted at each balance sheet date to reflect the exchange rate prevailing at that date. Gains and losses arising from translation of foreign currency monetary assets and liabilities at each period end are included in earnings. The accounts of certain subsidiaries, which are considered to be integrated operations, are translated into US dollars using the temporal method. Under this method, monetary assets and liabilities of foreign subsidiaries are translated at exchange rates in effect at the end of each period and non- FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) monetary assets and liabilities are translated using historical exchange rates. Revenues and expenses are translated at the average exchange rate for the period. Foreign currency transaction gains and losses are included in the determination of net income or loss. The accounts of other subsidiaries 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 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 liabilities, 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 instrument’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). Financial and non-financial derivative instruments are 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 associated market index. The Company has designated each of its significant categories of financial instruments as follows: Financial Instrument Classification Measurement Cash and Cash Equivalents Short Term Investments Accounts Receivable Held-for-trading Held-for-trading Loans and receivables Fair value Fair value Amortized cost Long Term Receivables Loans and receivables Amortized cost Derivatives Held-for-trading Fair value Accounts Payable and Accrued Liabilities Due to Related Parties Other liabilities Other liabilities Amortized cost Amortized cost Long Term Liability Other liabilities Amortized cost 67 02. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts t) Derivatives and Trading Activities The Company employs metals contracts, including forward contracts to manage exposure to fluctuations 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, Long Term Investments and Receivables are now included in Deposits on Long Term Assets. v) Recently released Canadian Accounting Standards The Company has assessed new and revised accounting pronouncements that have been issued and determined that the following will 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. 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. 68 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 approximately 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 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 03. ACQUISITION OF MINING INTEREST (continued) per share for consideration of $5,194 (CAD$6,651). A valuation date of March 6, 2009 was determined 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. 69 04. SHORT TERM INVESTMENTS Held-for-Trading Short term investments December 31, 2010 December 31, 2009 Fair Value $ 20,509 $ 20,509 Cost $ 20,509 $ 20,509 Fair Value $ 6,034 $ 6,034 Cost $ 6,034 6,034 $ 05. DERIVATIVES The Company enters into forward commodity contracts as well as put and call option commodity arrangements to secure a minimum price level on part of its zinc and lead metal production. Additionally, for the unhedged balance of production, the Company enters regularly into short term forward and option metal contracts 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 forward sale and option contracts are settled against the arithmetic average of metal spot prices over the month in which the contract matures. 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. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 05. DERIVATIVES As at December 31, 2010, the Company had the following contracts outstanding: (continued) Type of contract Metal Lead Forward sale Zinc Forward sale Silver Long put Silver Short call Silver Long put Silver Short call Total tonnage (t) or ounces (oz) 210 t 240 t 90,000 oz 90,000 oz 50,000 oz 50,000 oz Settlement period March 2011 March 2011 January 2011 January 2011 January 2011 January 2011 As at December 31, 2009 the main contracts outstanding were the following: Type of contract Forward sale Forward sale Long put Short call Long put Short call Long put Short call Long put Short call Metal Lead Zinc Zinc Zinc Lead Lead Zinc Zinc Lead Lead Total tonnage (t) 1,800 1,050 2,100 2,100 1,200 1,200 3,150 3,150 2,850 2,850 Settlement period Jan 2010 – Jun 2010 Jan 2010 – Jun 2010 Jan 2010 – Jun 2010 Jan 2010 – Jun 2010 Jan 2010 – Jun 2010 Jan 2010 – Jun 2010 Jul 2010 – Dec 2010 Jul 2010 – Dec 2010 Jul 2010 – Dec 2010 Jul 2010 – Dec 2010 Price/t or Price/oz $2,500/t $2,415/t $28.00/oz $32.10/oz $29.00/oz $31.70/oz Price/t US$1,910/t US$1,787/t US$2,000/t US$3,010/t US$2,000/t US$2,975/t US$2,000/t US$3,010/t US$2,000/t US$2,974/t The estimated fair value of the outstanding liability in derivative contracts of $133 (2009: liability $3,055) 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, 2010 11,224 $ 1,327 903 13,454 $ December 31, 2009 7,154 $ 1,168 313 8,635 $ Accounts receivable and prepaid expenses include prepaid income tax of $nil (2009: $9), $39 (2009: $121) short term portion of the long term receivable, $57 (2009: $34) in guarantee deposits. Trade accounts receivable includes receivables from the sale of concentrates of $11,224 (2009: $7,154) and are aged as follows: 70 0-30 days 31-60 days 61-90 days over 90 days December 31, 2010 9,754 $ 1,057 413 - 11,224 $ December 31, 2009 7,154 $ - - - 7,154 $ The Company has no allowance for doubtful accounts (2009: $nil). FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 07. INVENTORIES Inventories consist of the following: Stockpile ore Concentrate inventory Materials and supplies December 31, 2010 1,274 $ 347 2,413 4,034 $ December 31, 2009 204 $ 651 1,474 2,329 $ The amount of inventory recognized as expenses during 2010 was $22,270 (2009: $17,755) and there has been no impairment during 2010 (2009: $nil). 08. DEPOSITS ON LONG TERM ASSETS Deposits on long term assets consist of advance payments to construction contractors and equipment providers, and other receivables that are long term in nature and consist of the following: Deposits on equipment Deposits to contractors Other December 31, 2010 2,996 $ 1,529 8 4,533 $ December 31, 2009 - $ - 16 16 $ Property, plant and equipment are comprised of the following: 09. PROPERTY, PLANT AND EQUIPMENT December 31, 2010 December 31, 2009 $ Land Buildings Machinery & equipment Equipment under capital lease Furniture & other equipment Transport units Work in progress $ 71 Accumulated Depreciation Net Book Value 329 $ Accumulated Depreciation Cost 316 $ Cost 329 $ 8,760 11,451 4,174 4,174 442 14,977 44,307 $ - $ 2,069 4,027 1,281 836 331 - 8,544 $ 6,691 7,424 2,893 3,338 111 14,977 35,763 $ 22,541 $ 4,740 10,152 3,249 1,627 430 2,027 Net Book Value 316 3,700 7,129 2,681 1,189 191 2,027 17,233 - $ 1,040 3,023 568 438 239 - 5,308 $ Machinery & equipment includes costs of $682 (2009: $526) and accumulated depreciation of $201 (2009: $131) resulting from the estimate for the asset retirement obligation. Work in progress includes construction costs of $1,029 (2009: $1,202) and $13,948 (2009: $825) related to the Caylloma, Peru and San Jose, Mexico properties, respectively. The net carrying amount of $2,503 (2009: $2,503) related to an idle plant in Mexico, is not being amortized while the San Jose, Mexico property is under construction. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 10. MINERAL PROPERTIES Mineral properties are located in Peru and Mexico and are comprised of the following: December 31, 2010 December 31, 2009 Caylloma, Peru San Jose, Mexico Tlacolula, Mexico Predilecta, Mexico Cost Depletion $ 51,971 $ 16,079 55,525 - - 76 - 118 $ 107,690 $ 16,079 a) Caylloma Project, Peru Write-off Net Book Value Cost Depletion 443 $ 35,449 $ 42,209 $ 11,685 - - 55,525 44,745 - - 76 - - 109 - 118 561 $ 91,050 $ 87,063 $ 11,685 $ $ Write-off $ Net Book Value 160 $ 30,364 43,654 - - 109 - $ 1,251 $ 74,127 1,091 For the year ended December 31, 2010, additions to the Caylloma mineral property includes development and exploration costs of $9,564 (2009: $6,122). During the year ended December 31, 2010, the Company wrote down exploration costs in the amount of $443 (2009: $160) as it was determined there are significant exploration risks and does not warrant drill testing of the property. b) San Jose Project, Mexico For the year ended December 31, 2010, additions to the San Jose mineral property consist of development and exploration costs capitalized of $5,781 (2009: $5,742), general and administrative costs to develop the mine of $2,308 (2009: $1,425), and asset retirement obligation of $1,626 (2009: $nil). Included in the additions for the San Jose property is $62 (2009: $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 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 the additions for the San Jose mineral property is depreciation of equipment involved in construction work of $317 (2009: $220) and $1 (2009: $141) received as interest on VAT recovered. 72 c) Tlacolula Project, Mexico 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 (“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. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 10. MINERAL PROPERTIES (continued) 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 $20 cash according to the terms of the option agreement. Refer to Note 22. d) Predilecta, Mexico During the first quarter of 2010, the Company sold its interest in the Predilecta mineral property, for cash consideration of $13 resulting in a loss of $100. 11. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Trade accounts payable Income taxes payable Payroll and other payables Restricted share unit payable December 31, 2010 3,968 $ 4,192 5,249 87 13,496 $ December 31, 2009 2,577 $ 2,949 2,557 - 8,083 $ Payroll and other payables includes $2,328 (2009: $1,084) attributable to workers’ participation under Peruvian law and $495 (2009: $nil) attributable to bonus accruals. 12. RELATED PARTY TRANSACTIONS The Company incurred charges from directors, officers, and companies having a common director or officer as follows: Years ended December 31, Transactions with related parties Consulting fees1 Salaries and wages2,3 Other general and administrative expenses3 $ $ 2010 175 174 185 534 $ $ 2009 145 122 159 426 73 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 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 10. c) and 22. December 31, 2010 Amounts due to/(from) related parties Owing (from)/to a director and officer4 (1) $ Owing to a company with common directors3 $ 41 40 $ December 31, 2009 (1) $ 50 $ 49 $ 4 Owing from a director includes non-interest bearing advances to Jorge A. Ganoza Durant at December 31, 2010 and 2009. 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, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 13. LEASES AND LONG TERM LIABILITIES Leases and long term liabilities are comprised of the following: Obligations under capital Lease Long term liability Deferred share unit payable Restricted share unit payable a) Obligations under Capital Lease December 31, 2010 462 $ 705 1,955 44 3,166 $ December 31, 2009 810 $ 644 - - 1,454 $ The following is a schedule of the Company’s capital lease obligations. These are related to the acquisition of mining equipment, vehicles, and buildings. Interest Rate Maturity Date December 31, 2010 December 31, 2009 Gross lease payments: Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Banco Internacional del Peru S.A.A. Banco Internacional del Peru S.A.A. Banco Internacional del Peru S.A.A. Scotia Bank Peru S.A.A. Banco Internacional del Peru S.A.A. Scotia Bank Peru S.A.A. Scotia Bank Peru S.A.A. Gross lease payments Less: interest Total payment, net of interest Less: current amount b) Long Term Liability 8.66% 8.20% 8.49% 8.34% 8.49% 6.75% 6.75% 4.00% 9.12% 9.75% 4.50% 9.75% 4.50% 4.85% 2010 2010 2010 2011 2011 2011 2011 2011 2011 2012 2012 2012 2012 2012 $ $ $ - - - 1 31 7 9 93 89 58 341 574 360 58 1,622 (77) 1,545 (1,083) 462 $ $ $ 104 261 60 15 107 17 22 205 185 101 - 936 - - 2,014 (165) 1,848 (1,038) 810 In May 2008, the Company acquired the Monte Alban II concession (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, 2010. 74 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 Liability at period end Less: current portion of long term liability December 31, 2010 644 $ - 644 - 61 705 - 705 $ $ December 31, 2009 970 (225) 745 (156) 55 644 - 644 $ FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 13. LEASES AND LONG TERM LIABILITIES (continued) Principal minimum repayment terms will be: 2011 2012 $ $ - 800 800 c) Contingent Liabilities The Caylloma mine closure plan was approved in November 2009 with total closure costs of $3,587 of which $1,756 is subject to an 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 estimated 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 $293. This bank letter of guarantee expires 360 days from December 2010. Banco Bilbao Vizcaya Argentaria, S.A., has also established bank letters of guarantee totalling $54 to provide an annual guarantee associated with an office lease contract and truck rentals. These bank letters of guarantee expire 360 days from June 2010. Interbank, a third party, has renewed the bank letter of guarantee in the amount of $2, in favor of the Peruvian Ministry of Energy and Mines, to allow a temporary concession to study electric power generation in the hydro electric power plant, to expire April 2011. d) Deferred Share Units Payable The deferred share units are recorded on the balance sheet at fair value. As at December 31, 2010, there are 409,097 (2009: nil) deferred share units outstanding with a mark-to-market value of $1,955 (2009: $nil). e) Restricted Share Units Payable 75 The restricted share units are recorded on the balance sheet at fair value. As at December 31, 2010, there are 219,114 (2009: nil) restricted share units outstanding with a mark-to-market value of $131 (2009: $nil) of which $87 is current (2009: $nil). Refer to Note 11. 14. ASSET RETIREMENT OBLIGATION A summary of the Company’s provision for asset retirement obligation (“ARO”) is presented below. Asset retirement obligation - beginning of year Additions to obligation Revisions in estimates Accretion expense, included in depreciation, depletion and accretion Foreign exchange impact Asset retirement obligation - end of year December 31, 2010 2,529 1,626 584 185 - 4,924 $ $ December 31, 2009 1,066 $ - 1,286 150 27 2,529 $ For the Caylloma Mine, the accretion expense of $185 (2009: $150) was calculated over the year using a risk free interest rate of 4.87% (2009: 7.46%). The Company had 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 had made an increase to the estimated amount of the asset retirement obligation of FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 14. ASSET RETIREMENT OBLIGATION (continued) $584 (2009: $1,286) with a foreign exchange impact of $ nil (2009: $27). As at December 31, 2010, the accrued obligation was estimated using an undiscounted cash flow of $3,587 (2009: $3,346), a risk free rate of 4.87% (2009: 7.46%), mine life of 8.17 years (2009: 9.67 years), and Nuevo Soles to United States dollars foreign exchange rate of 2.809 (2009: 3.011). The accrued obligation at December 31, 2010 is $3,298. Refer to Note 13 c). For the San Jose mine development, the Company estimated the ARO using a undiscounted cash flow of $2,540 (2009: $nil), a risk free rate interest rate of 4.945% (2009: nil), a mine life of 9 years, and Mexican Pesos to United States dollars foreign exchange rate of 12.610 (2009: nil). Accretion expense over the year is $nil (2009: $nil) and the accrued obligation at December 31, 2010 is $1,626 (2009: $nil). 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. 15. INCOME TAX a) Income tax expense differs from the amount that would be computed by applying the Canadian statutory income tax rate of 29% (2009 - 30%) to income 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 (deductible) non-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, 2010 26,975 $ December 31, 2009 6,312 $ 29% 30% $ $ $ $ 7,688 (488) 2,535 431 24 3,830 14,020 10,940 3,080 14,020 $ $ $ $ 1,894 948 1,130 346 818 733 5,869 5,075 794 5,869 Current income taxes payable of $4,192 (2009: $2,949) is included within accounts payable and accrued liabilities in Note 11. 76 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 15. INCOME TAX (continued) b) The tax effects items that give rise to significant portions of the future tax assets and future tax liabilities at December 31, 2010 and 2009 are presented below: Future income tax assets: Non-capital losses Share issue costs Asset retirement obligation 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 Equipment Total future income tax liabilities Net future income tax liabilities December 31, 2010 December 31, 2009 $ $ $ $ 10,500 1,037 2,185 48 1,012 14,782 (10,553) 4,229 (13,360) (5,024) (178) (18,562) (14,333) $ $ $ $ 5,416 275 207 1,125 927 7,950 (6,599) 1,351 (10,366) (1,958) - (12,324) (10,973) c) The Company has non-capital loss carry-forwards that will expire if unused of $40,248 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 2030 No expiry Canada 380 1,129 915 - 2,139 2,342 3,850 1,597 4,674 9,876 - 26,902 $ $ $ $ Peru - - - - - - - - - - 357 357 $ $ Mexico - - 41 3,371 1,999 - - - 3,702 3,876 - 12,989 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. During the year ended December 31, 2010, the Company issued an aggregate of 26,507,500 common shares, under two bought deal financings, for gross proceeds of $78,528. Net proceeds of $73,919 after share issuance costs of $4,609 were raised from the bought deal financings comprised of: 77 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 16. SHARE CAPITAL (continued) 15,007,500 common shares at CAD$2.30 per share, for net proceeds of $31,135; and 11,500,000 common shares at CAD$4.00 per share, for net proceeds of $42,784. Subsequent to December 31, 2010 to March 23, 2011, the Company issued 6,756 common shares, at a fair market value of CAD$4.41 per share, to Radius (refer to Notes 10.c) and 22) and 245,000 share purchase options were exercised at prices ranging from CAD$0.83 to CAD$2.22 per share, resulting in issued and outstanding shares of 122,749,221. b) Stock Options The Company’s stock option plan, approved by the shareholders on August 30, 2006 and accepted by the TSX Venture Exchange on October 16, 2006 provides a rolling maximum of the issuance of common treasury shares equal to up to ten percent of the issued and outstanding common shares with no vesting provisions. The exercise price of the optioned shares are no less than the market price, with the length of the grant expiring up to ten years from grant. The following is a summary of option transactions: Balance, December 31, 2008 Granted Exercised Expired Forfeited Balance, December 31, 2009 Exercised Cancelled Balance, December 31, 2010 Number of Shares 7,734,000 2,915,000 (389,000) (970,000) (1,075,000) 8,215,000 (999,500) (2,665,000) 4,550,500 $ Weighted Average Exercise Price Per Share in CAD$ 1.87 1.56 0.81 2.35 3.22 1.50 1.03 1.62 1.51 $ $ During the period, 999,500 share purchase options with exercise prices ranging from CAD$0.80 to CAD$2.29 per share were exercised. During the period, 2,665,000 share purchase options with exercise prices ranging from CAD$1.60 to CAD$2.23 were cancelled as shareholder approval was not obtained at the Company’s annual general meeting held on June 23, 2010. 78 The following table summarizes information related to stock options outstanding and exercisable at December 31, 2010: Number of outstanding share purchase options (in 000’s) 1,621 1,800 1,130 4,551 Exercise price in CAD$ $0.80 to $0.99 $1.00 to $1.99 $2.00 to $2.75 $0.80 to $2.75 Weighted average remaining Weighted average contractual life exercise price on of outstanding outstanding share purchase options share purchase CAD$ options (years) 0.85 1.61 2.30 1.51 7.7 $ 5.5 6.1 6.4 $ Vested share purchase options (in 000’s) Weighted average exercise price on vested share purchase options CAD$ 0.85 1.61 2.30 1.51 1,621 $ 1,800 1,130 4,551 $ FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 16. SHARE CAPITAL (continued) The weighted average remaining life of vested share purchase options at December 31, 2010 was 6.4 years (2009: 8.3 years). As at December 31, 2010, 4,550,500 share purchase options have vested. Subsequent to December 31, 2010 to March 23, 2011, 245,000 share purchase options were exercised at prices ranging from CAD$0.83 to CAD$2.22 per share. c) Stock-based Compensation i. Stock Option Plan The Company uses the fair value based method of accounting for share options granted to consultants, directors, officers, and employees. The non-cash compensation recovery of $2,440 recognized for the year ended December 31, 2010 is associated with the 2,665,000 share purchase options granted in the fourth quarter of 2009 and cancelled as shareholder approval was not obtained at the Company’s annual general meeting held on June 23, 2010. The non-cash compensation charge of $2,707 recognized for the year ended December 31, 2009 is associated with options granted to a directors, officers, and employees. These compensation charges have been determined under the fair value method using the Black-Scholes option pricing model with the following assumptions: Risk-free interest rate Expected stock price volatility Expected term in years Expected dividend yield Years ended December 31, 2010 n/a n/a n/a n/a 2009 2.42% to 3.45% 70% to 78% 5 to 10 years 0% The weighted average grant date fair value of options granted during the year ended December 31, 2010 was CAD$nil (2009 - CAD$0.91). 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. ii. Deferred Share Units Cost During the year, the Company implemented a deferred share unit plan which allows for up to 1% of the number of shares outstanding from time to time to be granted to eligible directors. All grants under the plan are fully vested upon credit to an eligible directors’ account. As at December 31, 2010, there are 409,097 (2009: nil) deferred share units outstanding with a mark-to-market cost of $1,897 (2009: $nil). iii. Restricted Share Units Cost During the year, the Company implemented a restricted share unit plan for certain employees or officers. The RSUs entitle employees or officers to a cash payment after the end of each performance period, of 79 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 16. SHARE CAPITAL (continued) up to two years, following the date of the award. The RSU payment will be an amount equal to the fair market value of the Company’s common share on the five trading days immediately prior to the end of the performance period multiplied by the number of RSUs held by the employee. As at December 31, 2010, there are 219,114 (2009: nil) restricted share units outstanding with a mark-to-market cost of $127 (2009: $nil). d) Reserves During the year, the Board of Directors of Bateas has appropriated reserves of $975 (2009: $1,130) from its retained earnings representing ten percent of the net income earned in the calendar years 2009 (2009: 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. e) Weighted average number of common shares and dilutive common share equivalents Weighted average number of commons shares Weighted average number of dilutive stock options December 31, 2010 108,120 2,445 110,565 December 31, 2009 91,803 - 91,803 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 80 Year ended December 31, 2010 Sales Operating income (loss) Year ended December 31, 2009 Sales Operating income (loss) $ $ $ $ As at December 31, 2010 $ Mineral Properties Property, plant and equipment $ Total assets $ As at December 31, 2009 Mineral Properties $ Property, plant and equipment $ $ Total assets - $ (5,807) $ 74,056 $ 35,962 $ - $ - $ $ - (5,612) $ 51,428 $ 20,992 $ - $ (921) $ - 6 81,439 - 11 25,120 $ $ $ $ $ $ 35,449 $ 14,953 $ $ 77,760 55,601 $ 20,804 $ 83,973 $ 30,364 $ 12,298 $ 67,978 $ 43,763 $ 4,922 $ 46,614 $ - $ (44) $ - $ (76) $ - $ - $ 11 $ - $ 2 $ 26 $ 74,056 30,111 51,428 14,383 91,050 35,763 243,183 4,127 17,233 139,738 FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts c) Major Customers For the year ended December 31, 2010, there were two customers accounting for 64% and 36%, respectively, of the total sales of the Company. For the year ended December 31, 2009, there was one customer accounting for 94% of total sales of the Company. 17. SEGMENTED INFORMATION (continued) 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 the Company 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 annually 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, 2010, these obligations amounted to $711 with $231 and $480 maturing in 2011 and 2012, respectively. 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. 81 Estimated future reclamation costs are based principally on legal and regulatory requirements. As of December 31, 2010, $4,924 (2009: $2,529) was accrued for reclamation costs relating to mineral properties in accordance with Section 3110, “Asset Retirement Obligations”. See Note 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. 18. COMMITMENTS AND CONTINGENCIES (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 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. d) Credit Facility In 2010, the Company entered into a credit agreement with the Bank of Nova Scotia for a $20 million senior secured revolving credit facility (“credit facility”) to be refinanced or repaid on or within two and one-half years or before December 2012. The credit facility is secured by a first ranking lien on Bateas and its assets. The interest margin on drawings under the facility ranges from 4% to 4.5% depending on the leverage ratio. A stand-by fee between 1.25% and 1.5% depending on the leverage ratio is to be paid on the undrawn amounts under the facility. No funds were drawn from this credit facility during the year. 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 bank loan, 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 makes 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, 2010, are sufficient for its present needs for the next 12 months. The Company is not subject to externally imposed capital requirements. The Company’s overall strategy with respect to capital risk management remained unchanged during the year. 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. 82 a) Fair Value of Financial Instruments The carrying value of cash and cash equivalents, short term investments, accounts receivable, accounts payable and accrued liabilities, and due to related parties 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 uncertainties and matters of significant judgement and, therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 20. MANAGEMENT OF FINANCIAL RISK (continued) The analysis of financial instruments that are measured subsequent to initial recognition at fair value can be categorized into Levels 1 to 3 based upon the degree to which the fair value is observable. • 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 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. Cash and cash equivalents Short term investments Accounts receivable Derivatives $ $ $ Financial assets (liabilities) at fair value as at December 31, 2010 Level 1 Total 70,298 70,298 20,509 20,509 12,551 - (133) - 103,225 90,807 Level 2 - - 12,551 (133) 12,418 Level 3 - - - - - $ $ $ $ $ There were no changes in the levels during the year ended December 31, 2010. Cash and cash equivalents Short term investments Accounts receivable Derivatives $ $ $ Financial assets (liabilities) at fair value as at December 31, 2009 Level 1 Total 30,763 30,763 6,034 6,034 8,322 - (3,055) - 42,064 36,797 Level 2 - - 8,322 (3,055) 5,267 Level 3 - - - - - $ $ $ $ $ 83 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 to 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 counterparties the Company believes to be creditworthy. During the year ended December 31, 2010, there have been no changes in the classification of financial assets and liabilities in level 3 of the hierarchy. 20. MANAGEMENT OF FINANCIAL RISK (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 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, 2010, 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 and cash equivalents Short term investments Accounts receivable Long term investment and receivable Accounts payable and accrued liabilities Long term liability Asset retirement obligation December 31, 2009 Nuevo Soles December 31, 2010 Canadian Dollars $ 54,782 S/. 20,514 71 - (625) (1,999) - 741 $ - 1,304 - (27,268) (9,169) - Mexican Pesos 2,201 $ 21,283 S/. Canadian Dollars - 42,452 24,209 (6,390) - (19,959) 560 5 - (194) - - Nuevo Soles 302 $ - 880 - (17,150) - (8,835) Mexican Pesos 1,283 - 6,565 - (623) - - Based on the above net exposure as at December 31, 2010, 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 Impact to net income (loss) $ 8,081 $ (1,360) $ 382 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 and 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. 84 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, 2010, the Company has a Mexican value added tax of $3,336 and Peruvian value added tax of $136. The Company expects to recover the full amounts from the Mexican and Peruvian Governments. 20. MANAGEMENT OF FINANCIAL RISK (continued) FORTUNA SILVER MINES INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009 All amounts expressed in thousands of US Dollars, except for share and per share amounts 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. Expected payments due by period as at December 31, 2010 Accounts payable and accrued liabilities Due to related parties, net Derivatives Long term liability Total1 $ $ Less than 1 year 13,496 40 133 1,083 14,752 $ 1-3 years $ - $ - - 3,243 3,243 $ 4-5 years After 5 years - $ - - - - $ - $ - - - - $ Total 13,496 40 133 4,326 17,995 1 Amounts above do not include payments related to the following: (i) the Company’s anticipated asset retirement obligation of $4,924 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, lead, and copper 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. Cash received or paid for interest and income taxes: Cash received for interest Cash paid for income taxes Non-cash Transactions: Issuance of shares on purchase of resource property Reassessment of asset retirement obligation Cancellation of Minera Condor liability Equipment purchased through capital lease Fair value of options exercised Disposal of investment in subsidiary Notes 10 c) 14 13 b) Years ended December 31, 2010 335 4,346 20 2,210 - 925 759 119 $ $ $ $ $ $ $ $ 2009 210 596 5,194 1,286 156 1,425 246 - $ $ $ $ $ $ $ $ 85 21. SUPPLEMENTAL CASH FLOW INFORMATION 22. SUBSEQUENT EVENT UP TO MARCH 23, 2011 On January 14, 2011, the Company issued 6,756 common shares of the Company to Radius, at a fair market value of $4.44 per share and paid $30 cash according to the terms of the option agreement referenced in Note 10.c). 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 Management Head Office Carlos Baca Corporate Office Ralph Rushton / Erin Ostrom info@fortunasilver.com . c n I a i d e M e v i t a e r C n a m t i H : I N G S E D 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 Vancouver, BC Canada V7X 1P4 Share Transfer Agent Olympia Trust Company 750 West Pender Street, Suite 1003 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. 86 Photo: San Jose Mine: Processing plant ore transport conveyor belt underground tunnel www.fortunasilver.com TSX: FVI Lima Stock Exchange: FVI Frankfurt: F4S.F OTC:BB: FVIT.F Photo: San Jose Mine: Processing plant flotation cells and ball mill 

Continue reading text version or see original annual report in PDF format above