Fortuna Silver Mines Annual Report 2011

Plain-text annual report

BUILDING SUSTAINABLE VALUE 2011 ANNUAL REPORT Cover photo: San Jose Mine, Mexico Symbols Ag silver Ag Eq silver equivalent Au Cu g/t m koz M gold copper grams per metric tonne meters 1,000 ounces million Moz 1,000,000 ounces oz Pb t troy ounce. One troy ounce is equal to 31.1035 grams lead metric tonne tpd metric tonnes per day. One metric tonne equals 2,204.62 pounds Zn zinc Caylloma Mine, Peru Our Vision To be valued by our workers, the community and our shareholders as a leading silver mining company in Latin America. Our Mission To create value through the growth of silver reserves, metal production and the efficient operation of our assets with a commitment to safety, social and environmental responsibility. Our Values We value the health and safety of our workers: We do not tolerate unsafe acts or conditions. We value the environment: We subscribe to the highest environmental standards. We value our neighbours and other stakeholders: We respect cultural diversity and work as a strategic partner towards the sustainable development of neighbouring communities. We value the commitment to excellence: We achieve high standards and best practices. We value integrity: We act according to our philosophy. Table of Contents 2011 Performance 2 4 5 Outlook for 2012 Historical Milestones 6 Mineral Reserves & Resources Fueling Growth CEO’s Letter Chairman’s Letter Senior Management & Directors 8 9 11 12 14 16 16 18 20 22 24 25 57 Operational Highlights Caylloma Mine San Jose Mine Mario Property Silver Analysis Financial Review Management’s Discussion & Analysis Consolidated Financial Statements Social Responsibility 101 Corporate Data This annual report contains forward-looking statements. Please refer to the cautionary language under the heading “Cautionary Statement on Forward-Looking Statements” on page 55 of the Management’s Discussion & Analysis. FORTUNA SILVER MINES INC. Fortuna Silver Mines Inc. is a profitable silver producer with two 100%-owned, low-cost mines in Peru and Mexico. One of Latin America’s fastest growing silver miners, Fortuna has increased annual production steadily to approximately 2.8 million silver equivalent ounces since its establishment in 2005. Fortuna’s growth strategy is to focus on exploration and development of opportunities within its 73,000 hectare land holdings in Peru and Mexico while also pursuing select advanced stage silver projects in Latin America. Fortuna is headquartered in Vancouver, Canada and maintains management offices in Lima, Peru. Its common shares are listed on the New York Stock Exchange (FSM), Toronto Stock Exchange (FVI), Bolsa de Valores de Lima (FVI) and Frankfurt Stock Exchange (F4S.F). PRODUCING MINES San Jose Mine, Mexico San Jose achieved commercial production in September 2011 at 1,000 tpd and is expected to produce 1.7 million ounces of silver and 15,000 ounces of gold in 2012. Fortuna plans to initiate an expansion program in 2012 to increase mine and mill production capacity to 1,500 tpd. When operating at design capacity, San Jose is projected to produce approximately 3.2 million ounces of silver and 25,000 ounces of gold annually. During 2012, the company’s brownfields exploration program will focus on the testing and evaluation of opportunities developed in its 58,000 hectare land package. Caylloma Mine, Peru Over the past four years, the company has increased silver production at Caylloma by more than 200%. In 2011, the mine produced 2 million ounces of silver and 2,400 ounces of gold, plus base metal by- products. Caylloma’s Mine life is projected at eight years. In 2012, Fortuna will conduct brownfields exploration to evaluate a number of high-grade silver targets on its 11,000 hectare land package. Concentrate shipment at the San Jose Mine, Mexico 1 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 1 PERFORMANCE San Jose Mine, Mexico 2011 PERFORMANCE Milestones • Silver production increases by 31% to 2.5 million ounces • Sales increase by 49% to a record US$110 million • Earnings per share increase by 7% to US$0.16 • San Jose Mine achieves commercial production on time and on budget at 1,000 tpd in September • Fortuna acquires option to purchase 100% interest in the Mario project in central Peru • Exploration continues to increase mineral resources and reserves • Common shares begin trading on the New York Stock Exchange Financial Highlights (Expressed in thousands of US dollars) Sales Operating income Net income Earnings per share Cash flow from operations 2011* 110,004 38,065 19,533 0.16 35,508 2010* 74,056 27,728 16,003 0.15 21,713 2009** 51,428 14,383 623 0.01 13,686 * Figures expressed under IFRS ** Figures expressed under Canadian Generally Accepted Accounting Principles Capital Share Structure (As of April 13, 2012) Shares outstanding Stock options Warrants 125,268,751 3,688,289 0 2 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT PERFORMANCE Operating Highlights Processed Ore Tonnes milled Average tpd milled Cash Cost (US$/oz Ag) (1) Silver (2) Grade (g/t) Recovery (%) Production (oz) Realized Price (US$/oz) (3) Gold Grade (g/t) Recovery (%) Production (oz) Realized Price (US$/oz) (3) Lead Grade (%) Recovery (%) Production (000 lbs) Realized Price (US$/lb) (3) Zinc Grade (%) Recovery (%) Production (000 lbs) Realized Price (US$/lb) (3) Copper Grade (%) Recovery (%) (4) Production (000 lbs) Realized Price (US$/lb) (3) No. of Employees 2011 2010 2009 Caylloma Mine Peru San Jose Mine (5) Mexico Consolidated Peru Peru Caylloma Mine Caylloma Mine 125,301 949 4.51 144 84.60 490,555 1.36 84.40 4,622 – – – – – – 448,866 1,272 (0.59) 171 81.43 2,008,488 0.36 45.71 2,393 2.15 92.68 19,677 2.68 88.46 23,424 0.18 2.03 36 434,656 1,231 (5.99) 395,560 1,121 (4.86) 0.37 159.24 85.67 1,906,423 18.18 154.76 85.40 1,682,546 13.09 2,499,043 31.11 0.40 46.28 2,556 921 2.44 91.28 21,373 0.79 3.10 87.99 26,137 0.60 0.21 51 1,026 2.60 1,630 0.47 46.45 2,780 707 3.10 93.02 25,137 0.56 3.66 89.07 28,442 0.39 0.25 – 190 1.53 885 7,015 1,183 19,677 0.86 23,424 0.66 80.275 2.65 1,502 1 Net of by-product credits 2 2011 Caylloma Mine silver recovery in lead concentrates. 2009 and 2010 Caylloma Mine silver recovery in lead and copper concentrates 3 Calculated based on contained metals and after deductions, treatment, and reﬁning charges. Treatment charges are allocated to the base metals in Caylloma and to gold in San Jose. Net realized prices are based on provisional sales and are calculated before government royalties 4 Copper recovery in 2009 was not reported as circuit was fully commissioned in December 2009 5 Total production for 2011, includes pre-commissioning production. Commercial production as of September 1st, 2011: Tonnes milled: 116,410, average tpd milled: 954, silver grade (g/t): 150, silver recovery (%): 84.95, silver production (oz): 478,167, gold grade (g/t): 1.43, gold recovery (%): 84.62 and gold production (oz): 4,524 Sales by Metal Gold 7% Copper 4% Gold 3% Copper 1% Gold 4% Silver 64% Zinc 14% Lead 15% Silver 49% Zinc 21% Silver 43% Zinc 23% 2011 2010 2009 Lead 23% Lead 29% FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 3 CAYLLOMA MINE OUTLOOK FOR 2012 Opening Bell Ceremony at the New York Stock Exchange January 17, 2012 OUTLOOK FOR 2012 Production Guidance Mine Caylloma, Peru San Jose, Mexico Total Silver (Moz) Gold (koz) Zinc (Mlbs) Lead (Mlbs) 2.0 1.7 3.7 2.4 15.0 17.4 21.0 -- 21.0 18.0 -- 18.0 2012 – 2015 Production Forecast 2014E production: 6.4M Ag Eq oz + base metals z o n o i l l i M q E g A 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Caylloma Mine base metal Ag Eq San Jose Mine Ag Eq (Ag + Au) Caylloma Mine Ag Eq (Ag + Au) 2007 2008 2009 2010 2011 2012 2013 2014 2015 Ag Eq calculated using Ag = US$30/oz, Au = US$1,660/oz, Pb = US$2,300/t and Zn = US$2,000/t 4 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT I HISTORICAL MILESTONES Core shack at Caylloma Mine, Peru HISTORICAL MILESTONES 2005 • Fortuna Silver Mines Inc. is established • Shares begin trading on the Toronto Venture Exchange under the ticker “FVI” • Fortuna acquires 100% interest in the Caylloma Mine 2006 • Caylloma Mine resumes production at approximately 500 tpd • Fortuna purchases 76% interest in the San Jose project 2007 • Silver and gold resources increase significantly at San Jose project 2008 • Annual silver production increases by 85% • Shares begin trading on the Bolsa de Valores de Lima under the ticker “FVI” 2009 • Annual silver production reaches a record 1.7 million ounces • Fortuna completes acquisition of 100% interest in the San Jose project • Environmental Impact Study approved for San Jose project 2010 • Fortuna raises more than C$80 million in two bought-deal financings • Common shares upgraded to Toronto Stock Exchange from Toronto Venture Exchange • San Jose Mine construction commences FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 5 MINERAL RESERVES & RESOURCES MINERAL RESERVES & RESOURCES Mineral Reserves – Proven & Probable Contained Metal Property Classification Tonnes (000) Ag (g/t) Au (g/t) Pb (%) Zn (%) Ag (Moz) Au (koz) Caylloma, Peru Silver Veins Polymetallic Veins Proven Probable Proven + Probable Proven Probable Proven + Probable Combined – All Veins Proven Probable Proven + Probable San Jose, Mexico Probable Total Proven + Probable 26 755 781 1,318 2,543 3,861 1,344 3,297 4,642 3,600 8,241 687 365 376 87 86 86 98 150 135 204 165 0.28 0.42 0.42 0.32 0.31 0.31 0.32 0.34 0.33 1.59 0.88 0.32 0.06 0.07 1.59 1.58 1.59 1.57 1.23 1.33 N/A N/A 0.32 0.06 0.07 2.39 2.27 2.31 2.35 1.76 1.93 0.6 8.9 9.4 3.7 7.1 10.7 4.2 15.9 20.2 0.2 10.3 10.5 13.5 25.5 39.0 13.7 35.8 49.5 N/A 23.6 183.7 N/A 43.8 233.2 Mineral Resources – Measured and Indicated Contained Metal Property Classification Tonnes (000) Ag (g/t) Au (g/t) Pb (%) Zn (%) Ag (Moz) Au (koz) Caylloma, Peru Measured Indicated Measured + Indicated 574 1,684 2,258 100 131 123 0.31 0.30 0.30 1.17 0.74 0.85 1.75 1.11 1.28 1.8 7.1 8.9 5.8 16.0 21.8 San Jose, Mexico Indicated 376 243 2.12 N/A N/A 2.9 25.6 Total Measured + Indicated 2,634 140 0.56 N/A N/A 11.9 47.4 Mineral Resources – Inferred Contained Metal Property Classification Caylloma, Peru San Jose, Mexico Total Inferred Inferred Inferred Tonnes (000) 3,258 3,072 6,330 Ag (g/t) 112 223 166 Au (g/t) Pb (%) Zn (%) Ag (Moz) Au (koz) 0.36 0.99 1.50 11.8 37.9 1.80 N/A N/A 22.0 178.1 1.06 N/A N/A 33.8 216.0 1. Mineral Reserves and Mineral Resources are as deﬁned by CIM Deﬁnition Standards on Mineral Resources and Mineral 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 Resources and Mineral Reserves are estimated as of June 30, 2011 and reported as of December 31, 2011 taking into account production-related depletion for the period of July 1, 2011 through December 31, 2011 5. Caylloma Mineral Reserves are estimated using break-even cut-off grades based on estimated NSR values using assumed metal prices of US$26.59/oz Ag, US$1,279.31/oz Au, US$2,116/t Pb and US$2,028/t Zn; historical metallurgical recovery rates of 82% for Ag, 45% for Au, 93% for Pb and 88% for Zn; and historic operating costs adjusted for inﬂation. Caylloma Mineral Resources are reported based on estimated NSR values using the aforementioned assumed metal prices and metallurgical recovery rates and a cut-off value of US$30/t 6. 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 1,077,000 tonnes averaging 197 g/t Ag, 0.39 g/t Au, 1.00% Pb and 1.28% Zn. Inferred Oxide Resources are estimated at 544,000 tonnes averaging 143 g/t Ag, 0.27 g/t Au, 0.55% Pb and 0.94% Zn 7. San Jose Mineral Resources are estimated as of December 10, 2009 with Mineral Reserves estimated as of December 31, 2010 and actualized as of December 31, 2011 taking into account production-related depletion from start-up in August 2011 through December 31, 2011 8. San Jose Mineral Reserves are estimated using break-even cut-off grades based on assumed metal prices of US$15.12/oz Ag and US$897.51/oz Au, estimated metallurgical recovery rates of 88% for Ag and 90% for Au and projected operating costs. San Jose Mineral Resources are estimated and reported at a Ag Equivalent cutoff 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)) 9. Totals may not add due to rounding procedures 10. N/A = Not Applicable 6 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 2 2 MINERAL RESERVES & RESOURCES Sustainable Mineral Reserve and Resource Growth z o n o i l l i M q E g A 140 120 100 80 60 40 20 0 2005 2006 2007 2008 2009 2010 2011 Ag Eq calculated using Ag = US$25.14/oz and Au = US$1,391.63/oz Inferred Resources Measured + Indicated Resources Proven + Probable Reserves FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 7 Grade control sampling at Caylloma Mine, Peru FUELING GROWTH Caylloma Mine, Peru FUELING GROWTH Fortuna’s growth strategy is to focus on expanding its resource base by exploring for high-grade silver mineralization within its core land holdings in Peru and Mexico. To further leverage this growth, the company is selectively pursuing the acquisition of advanced-stage, silver-rich projects in Latin America with potential for low-cost operations. The objective is to achieve annual production of 14 million silver equivalent ounces by 2016: 7 million ounces from current reserves and mine plans and 7 million from new reserves. To achieve this objective, management has implemented the following strategic initiatives in 2012: Maximize production, profitability and cash flow • Initiate expansion of San Jose’s mill and mine production capacity to 1,500 tpd • Focus on operational efficiencies to reduce cash costs • Convert silver/gold concentrate to dore production at San Jose Capitalize on brownfields exploration opportunities at San Jose and Caylloma • Conduct 44,000 meters of exploration drilling • Generate high-priority silver-gold targets through exploration of extensive land holdings Pursue M&A opportunities in Latin America • Evaluate advanced-stage projects with potential for at least 50% of revenue from silver • Pursue projects with potential for low-cost operations The objective is to achieve annual production of 14 million silver equivalent ounces by 2016: 7 million ounces from current reserves and mine plans and 7 million from new reserves. 8 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT CHIEF EXECUTIVE OFFICER’S LETTER Our consolidated production budget for 2012 is 3.7 million ounces of silver and 17,000 ounces of gold, a 48% increase in silver production and more than double the gold output of 2011. CHIEF EXECUTIVE OFFICER’S LETTER To our shareholders, employees and stakeholders, 2011 was a year of transformation marked by several important milestones. In September, we started commercial production on time and on budget at our San Jose Mine in Mexico. San Jose is our second operating mine and fundamental to the continued growth of silver and gold production in the next two years. Also in September, our shares began trading on the New York Stock Exchange, the world’s premier securities market. Additionally, Fortuna achieved record sales and silver production. Creating sustainable value At the start of 2012, we had capital and exploration budgets of US$70 million for sustaining our aggressive long-term growth strategy. By mid-2013, I expect Fortuna to achieve an annual production rate of approximately 5.2 million ounces of silver and 27,000 ounces of gold from existing reserves and mine expansion plans. In the meantime, I am optimistic that our search for attractive silver projects in Latin America will enable us to further expand our property portfolio. The listing of Fortuna´s common shares on the New York Stock Exchange on September 19, 2011 and the opening bell ceremony on January 17, 2012 gave us many reasons to celebrate. Those highlights also caused us to pause and reflect on our achievements. As a group — management, directors and employees — we reminisced about the beginnings of Fortuna in 2004, when we came together with the vision of building a leading silver mining company in Latin America. We took this opportunity to renew our commitment to that vision and to our values. Entering 2012 with ambitious yet realistic plans Our consolidated production budget for 2012 is 3.7 million ounces of silver and 17,000 ounces of gold, a 48% increase in silver production and more than double the gold output of 2011. The San Jose Mine is scheduled to produce 1.7 million ounces of silver and 15,000 ounces of gold. Caylloma is expected to produce 2 million ounces of silver and 2,000 ounces of gold, plus base metals. Our estimated consolidated cash production cost is approximately US$6 per ounce of silver, net of by-product credits. This is below the median production cost among silver producers. The silver mining industry benefited from continued strong silver prices in 2011. Driven by growth in investment and industrial demand, silver prices averaged US$35 per ounce, a 74% increase over the average price in 2010. At the same time, the industry faced challenges from rising operating costs. Our cash cost at Caylloma increased significantly over the year driven by industry related inflation mainly in wages and mining services which accentuated in Q4 2011. We do not expect significant cost increase in 2012 from our cost reported for Q4 2011. In response to these cost pressures, Fortuna has implemented several initiatives aimed at improving productivity, maintaining strong financial margins and increasing production. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 9 CHIEF EXECUTIVE OFFICER’S LETTER Fortuna has implemented several initiatives aimed at improving productivity, maintaining strong financial margins and increasing production. At the San Jose Mine, we will increase production capacity from 1,000 tpd to 1,500 tpd and build a silver- gold dore production facility, which will significantly reduce treatment charges related to the sale of gold and silver concentrates. The 2012 capital budget for these projects is US$25 million. At the Caylloma Mine, we plan to invest US$30 million in 2012 to improve underground mining efficiency and upgrade energy, plant and camp infrastructure. The projects at both mines will be pivotal in supporting our cost competitiveness and growth. Generating new growth opportunities The highlight of our exploration and project-generation activities in 2011 was the signing of an option agreement to acquire a 100% interest in the Mario Property. Located in central Peru, Mario is a post- discovery stage project with good potential for bulk-minable, epithermal gold-and-silver mineralization, as well as high-grade replacement style silver-and-base metal mineralization. Our first-phase drilling program at Mario started in November 2011 and continued into the first quarter of 2012. At the Caylloma Mine, our exploration programs replaced 670,000 tonnes of reserves consumed through production. More importantly, this work increased reserves of the high-grade silver-rich veins in the central portion of our holdings. We now have a proven and probable reserve base of approximately 20 million ounces of silver, supporting an eight-year mine life. Our exploration budget overall for 2012 is US$15 million. This includes plans for drilling approximately 44,000 meters in brownfields and greenfields exploration programs at our projects in Peru and Mexico. Maintaining our commitment to sustainability As an organization, we remain committed to the three cornerstones of our values: maintaining the health and safety of our personnel, subscribing to the highest environmental standards and respecting our host communities. Despite our best efforts to uphold safe work practices, a fatal accident at the Caylloma Mine in February 2012 claimed the life of Mr. Sixto Chambilla Apaza, a driller working for one of our mine contractors. This is the first fatal accident at Fortuna in six years of operations. Following a thorough analysis of the accident, we have adopted all recommendations of the investigation team. We are implementing company- wide measures to ensure that additional safeguards are in place to prevent violations of the safety regulations and procedures that led to this tragic accident. Our company actively works as a strategic partner in the communities that host our operations. We collaborate with local stakeholders to identify opportunities where we can establish and participate in sustainable community development projects and social responsibility initiatives. During 2011, Fortuna funded US$1.3 million in various projects. These ranged from genetic improvement of local Alpaca herds near our Caylloma Mine, to road construction and school scholarships in Mexico. In closing, I commend the extraordinary group of people that make up our team. More than 1,500 employees and contractors located in three countries are working together every day to realize our vision. I also extend my thanks to our Board of Directors for their continued leadership and support. 10 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT Jorge A. Ganoza President and Chief Executive Officer CHAIRMAN’S LETTER Our goal is to become an industry leader in the Americas. CHAIRMAN’S LETTER To our shareholders and employees, In 2004, we set out to build a company that would capitalize on the favourable long-term outlook for silver and on Latin America’s growing dominance in silver production. Then, as now, our objectives are to create a leading silver producer, to generate rapid growth and to recruit and retain top talent to manage our growth. I am delighted with how the Fortuna team continues to embrace our objectives and work tirelessly to meet them. We have made tremendous progress from our small beginnings as a junior resource company. Today, our growth potential is the strongest it has ever been, given the steadily increasing value and potential of our core assets. Since the formation of our company, we have always emphasized building sustainable value. Our goal is to become an industry leader in the Americas by maintaining a commitment to growth and to the well-being of our workers, neighbouring communities and the environment. Our success, however, won’t be determined solely by the volume and value of the metals that we mine. Rather, it will also be measured by the economic, social and environmental sustainability of our operations. And in that respect, we have much to be proud of. I believe that our approach to creating sustainable value was key to the fast-track development of our San Jose Mine. The Fortuna team quickly and efficiently advanced San Jose from acquisition and initial sampling to commercial production in just five years. This remarkable achievement adds considerable value to the reputation of our company. Similarly, the recent listing of our common shares on the New York Stock Exchange benefits both our company and our shareholders, providing additional liquidity to investors and access to capital to support Fortuna’s growth plans. Fortuna has evolved and grown rapidly in recent years, yet its strategy of focussing on silver projects in Latin America remains relevant. We believe that Latin America offers a rich hunting ground for new projects. The region hosts the top two silver producing countries in the world, Mexico and Peru, and boasts a safe, mining-friendly culture in most countries. Additionally, the outlook for silver demand remains bright. Industrial demand is forecast to grow by 36% from 2010 through 2015, according to the Silver Institute. Demand is expected to remain positive primarily because of the lack of substitution and the wide range of established and ever-growing new uses of silver that are vital to industry. As always, it is my pleasure to thank the entire Fortuna family for their exceptional dedication, enthusiasm and teamwork. Like every mining company, we face challenges and opportunities day in and day out. Fortuna, however, has the credibility, industry expertise and solid financial growth to remain on track to achieving its long-term objectives. On behalf of my fellow directors, I also thank our shareholders for your continued loyalty and support. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 11 Simon Ridgway Chairman of the Board SENIOR MANAGEMENT & DIRECTORS SENIOR MANAGEMENT Jorge A. Ganoza, Geological Engineer President, CEO and Director Thomas I. Vehrs, Ph.D. Vice President of Exploration Luis Dario Ganoza, B. Sc. Engineering, MBA, M. Sc. Chief Financial Officer Manuel Ruiz-Conejo, B. Sc. Engineering Vice President of Operations Cesar Pera Vice President of Human and Organizational Development Jorge A. Ganoza is a geological engineer with over 16 years of experience in exploration, mining and business development throughout Latin America. A graduate of the New Mexico Institute of Mining in 1994, Jorge is a fourth generation miner from a Peruvian family that has owned and operated underground mines in Peru and Panama. Jorge also serves as a Chairman of the Board of Atico Mining Corporation, a TSX.V listed company. Over the past 35 years, Dr. Thomas Vehrs has enjoyed a successful career in mineral exploration and mine development. During this time, he consulted to and held senior positions with several major mining companies and was a founder and acted as President and COO of Aquest Minerals Corp. Tom has worked extensively in Latin America developing and managing exploration programs with an emphasis on epithermal and porphyry-related mineralized systems. Tom also serves as an independent director of AQM Copper Inc. Luis D. Ganoza has 12 years of experience in the operation and financial management of mining companies. He has served as CFO of Fortuna Silver since 2006 and previously held the positions of Controller and Treasurer for a public mining company in Peru. Luis has a B.Sc. in mining engineering from the Universidad Nacional de Ingenieria in Peru, and an M.Sc. in accounting and finance from the London School of Economics. Luis also serves as a director of Atico Mining Corporation, a TSX.V listed company. A mining engineer with more than 25 years of experience, Manuel Ruiz-Conejo has worked for the most prolific polymetallic mines and mine contractors in Peru. As an engineer, he has participated in the execution of critical projects. As an executive, he has developed and supervised the implementation of several multimillion-dollar mining projects and numerous community relations initiatives. Manuel graduated from the Universidad Nacional de Ingenieria and from the Executive Management Program at the Universidad de Piura in Peru. Cesar Pera is an organizational psychologist with a master’s degree in organizational psychology from the University of Madrid. Cesar has over 25 years of experience in organizational development and change with Latin American companies. He served as President of the Peruvian Association of Human Resources and as Vice President of the Interamerican Federation of Human Management for the Andean region. Cesar serves as director of the Master’s Degree Program in Organizational Development and People Management at the Universidad del Pacifico in Peru. 12 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT SENIOR MANAGEMENT & DIRECTORS DIRECTORS Simon Ridgway Chairman of the Board Robert R. Gilmore, CPA Tomas Guerrero, Geological Engineer Michael Iverson Mario Szotlender Thomas Kelly Simon Ridgway is a prospector, a mining financier and a Casey Research Explorers’ League inductee. Grassroots exploration is Simon’s first love, and he has had a successful career as an explorationist since starting out in the Yukon Territory in the late 70s. Simon and the exploration teams under his guidance have discovered gold deposits in Honduras, Guatemala and Nicaragua. On the financial side, Mr. Ridgway has raised more than CAD$350 million for exploration and development projects since 2003. Robert Gilmore graduated from the University of Denver with a bachelor of science degree in business administration, accounting. Robert is a Certified Public Accountant and a member of the Colorado Society of Certified Public Accountants and the American Institute of CPAs. He has more than 30 years of experience working with resource companies and currently serves as Chairman of the Board for Eldorado Gold Corporation and as a director for Layne Christensen Company, a NASDAQ-listed US company with nearly US$1 billion in revenues. Tomas Guerrero is a geological engineer with over 30 years of mine geology and mineral exploration experience in Latin America. Until 2001, Tomas served for ten years as Director of Explorations for the Hochschild Group, a leading public Peruvian mining company. Under his leadership, Hochschild discovered and put in production three mid-size gold-silver mines. He is currently the principle of BO Consulting, an engineering consulting firm serving the mining sector. Michael Iverson has served as President and a director of Triple K Ventures Ltd. since 1975 and as President and a director of R.P. F. Custom Wood Fibre Ltd. since 1985. In 1997, Michael joined Sasha Ventures Ltd., a public company, as President and a director. In addition, Michael was Chief Executive Officer of Fortuna from 1998 to 2005, and has served as Secretary and a director of Niogold Mining Corp. since 1998. Mario Szotlender holds a degree in international relations and is fluent in several languages. He has directed Latin American affairs for numerous companies over the past 20 years, specializing in developing business opportunities and establishing relations within the investment community. He has been involved in various mineral exploration and development joint ventures and operations in Central and South America. Mario has served as President of Mena Resources Inc. and Rusoro Mining Ltd., and is currently a director of Radius Gold Inc. and Endeavour Silver Corp. Thomas Kelly has bachelor and masters degrees in mining engineering from the Colorado School of Mines and is a Fellow of the Australasian Institute of Mining and Metallurgy and a member of the Society for Mining, Metallurgy & Exploration. Tom has over 35 years of worldwide experience with mineral industry leaders such as Freeport- McMoRan Copper & Gold, AMEC Americas and Inca Pacific Resources. He is a recognized expert in project management and development and is fluent in Spanish. Tom is currently CEO of Apurimac Ferrum. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 13 SOCIAL RESPONSIBILITY Scholarship program for San Jose del Progreso community SOCIAL RESPONSIBILITY At Fortuna, we have implemented a series of projects aimed at improving health, education and infrastructure in the communities near our operations. At San Jose, we signed an agreement in 2011 with the Municipality of San Jose del Progreso to implement several projects for improving the well-being of residents and the local infrastructure. The main projects include construction of a health post, sports court and daycare centre. We also developed several programs in collaboration with the community aimed at improving education, health and culture. These include providing scholarships for primary and secondary school and college students, and home improvements such as upgrades to kitchens and construction of ecological bathrooms. At Caylloma, an agreement signed in 2010 with the Municipality of Caylloma opened the door to local development projects that train community members to work in our mine and provide educational support. Other initiatives include genetic enhancements of local alpaca herds to improve the quality of their wool and overall health, and support of the community’s activities to develop a self-sustaining local economy. We are also helping local artisanal weavers improve weaving techniques, granting scholarships, funding summer- school programs and working to improve nutrition and health in the communities. Program to improve kitchens at San Jose del Progreso community San Jose del Progreso medical post 14 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT SOCIAL RESPONSIBILITY Alpaca herd genetic improvement program at Caylloma Forging Strategic Partnerships • Programs are based on respect for ethno-cultural diversity, open communication and effective interaction with all stakeholders. • We work with communities towards self-development of economically sustainable activities to improve their quality of life. Teaching children about caring for the environment at Caylloma Pasture improvement program at Caylloma FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 15 CAYLLOMA MINE, PERU COMMODITIES: Silver, gold, lead and zinc OWNERSHIP: 100% LAND PACKAGE: 11,000 hectares LOCATION: Arequipa, Peru DEPOSIT TYPE: (Latitude 15° 13” S, Longitude 71° 49” W) Intermediate-sulphidation epithermal deposit STATUS: Mill and underground mine operating at over 1,250 tpd Exploration underway for veins with potential for high-grade silver mineralization CAYLLOMA MINE 16 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 4,500 meters above sea level CAYLLOMA MINE, PERU 1,300 tpd processing plant 2011 Results Silver production reached 2 million ounces in 2011 and has exceeded forecasts every year since the mine and mill were upgraded in 2006. In 2011, the cash cost per ounce of silver, net of by-product credits, was negative US$0.59, compared to negative US$5.99 in 2010. Cash costs were driven higher by inflationary pressure on labour costs and a decrease in by-product credits during the second half of the year. The decrease in by-product credits was due primarily to lower base metal prices (lead down 24%, zinc down 21%) and lower lead production, which declined by 13% from the previous year. Exploration Our exploration in 2011 led to the discovery of high-grade silver ore shoots in the Bateas vein and confirmed the exploration and discovery potential of this prolific mining district, which has been in semi- continuous production since the arrival of the Spaniards in the early 16th century. Outlook For 2012, the mine is scheduled to produce 2 million ounces of silver and 2,400 ounces of gold plus lead and zinc by-products. Our capital spending budget for the year is US$25 million and includes a new tailings facility with total holding capacity for 17 years and improvements to the power grid, plant equipment, camp and other infrastructure. Fortuna will also continue to scope production expansion of the mine in 2012. In 2011, the company received approval for an Environmental Impact Study to increase production capacity up to 2,250 tpd. An updated reserve and resource estimate has been completed and will be used to evaluate the next phase of mine expansion. The company’s exploration plans for 2012 include 24,000 meters of diamond drilling and 3,500 meters of underground drifting. This work will focus on high-grade silver targets, including extensions of bonanza- style mineralization in the following areas: • Bateas vein: Drilling will test the projected intersection with the San Cristobal vein that, along with the Bateas vein, has been a prominent producer throughout the mine’s history. • Animas vein: Drilling will target ore-grade intersections from earlier exploration programs of the Nancy structure, a subsidiary structure to the Animas vein. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 17 SAN JOSE MINE, MEXICO COMMODITIES: Silver and gold OWNERSHIP: 100% LAND PACKAGE: 58,000 hectares LOCATION: Taviche Mining District, Oaxaca, Mexico (Latitude 16° 41” N, Longitude 96° 42” W) DEPOSIT TYPE: High-grade, low-sulphidation, epithermal vein deposit STATUS: Mill and underground mine operating at 1,000 tpd Expansion to 1,500 tpd design capacity initiated in 2012 Exploration for high-grade silver veins underway SAN JOSE MINE 18 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 1,600 meters above sea level SAN JOSE MINE, MEXICO Ocotlan Grey Water Treatment Plant – source of 20% of San Jose’s water balance 2011 Results In July 2011, the company completed construction and commissioning of the San Jose Mine on time and on budget. Commercial production commenced on September 1, 2011 at a rate of 1,000 tpd. San Jose’s total metal production for 2011 was 490,555 ounces of silver and 4,622 ounces of gold at a cash cost of US$4.51 per silver equivalent ounce, net of by-product credits.(1) Exploration The San Jose land package holds potential for discovery of new gold-and-silver-bearing deposits within the 58,000 hectare concession area located in the general vicinity of the existing mill at San Jose. In 2012, the company’s program will focus on the continued exploration and evaluation of the southern extension of the Bonanza and Trinidad veins at the San Jose Mine as well as exploration of other targets within the district. Targets in evaluation and under consideration for drill testing include vein systems outcropping in the Tlacolula concession and the La Altona vein system in the Taviche District area. Early stage exploration activities will also be carried out in a number of locations within the concession area where previous work has identified significant gold and silver geochemical anomalies. Outlook For 2012, Fortuna expects the San Jose Mine to produce 1.7 million ounces of silver and 15,000 ounces of gold. The company has initiated construction activities to expand mine and mill capacity to 1,500 tpd. Once completed, San Jose is expected to produce at a rate of approximately 3.2 million ounces of silver, 25,000 ounces of gold, or 4.6 million silver equivalent ounces per year. The capital budget for the expansion project is US$30.7 million. 1 Total production for 2011, includes pre-commissioning production. Commercial production as of September 1st, 2011: Tonnes milled: 116,410, average tpd milled: 954, silver grade (g/t): 150, silver recovery (%): 84.95, silver production (oz): 478,167, gold grade (g/t): 1.43, gold recovery (%): 84.62 and gold production (oz): 4,524. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 19 MARIO PROPERTY, PERU COMMODITIES: Silver, gold, lead and zinc OWNERSHIP: Option to earn 100% interest LAND PACKAGE: 4,900 hectares LOCATION: Junin, central Peru MINERALIZATION: Massive sulphide replacement bodies, veins, mantos, hydrothermal breccias, disseminations and skarn-type bodies STATUS: Exploration stage MARIO PROPERTY 20 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MARIO PROPERTY, PERU Uchucchacua c cua Atachocha ha AtAtat ch Milpo o Iscaycruz ayc uz ca Ce Cerro de Pasco d d Quicay Qui Invicta Inv Met Metallogenic Belt etallogenic Silver – Lead – Zinc Silv ilver – Lead – M Maria Teresa Colquijirca ca lq Shalipayco Huaron uaro r Chungar n Puy Puy y Pu Puy San Vincente ro Morococha ocha Toromocho ho Toro m mm Casapalca al sa as s c San Cristobal tobal bal o to Cristobal st n Sa Juauja a Silveria-Germania Pachancoto Pa ococ Lima Palma cha Azulcocha yo Huancayo LEGEND LEGEND LEGEND Ag-Pb-Zn mine Ag-Pb-Zn mine Au-Ag mine Au-Ag mine Cu-Porphyry mine Cu-Porphyry mine Cu-Pb-Zn mine Cu-Pb-Zn mine City City Jumasha Limestone Jumasha Limestone Pucara Limestone Pucara Limestone 0 0 0 50 km 50 km 50 km MARIO PROPERTY Yauricocha ha co Yauuricocha Tucumachay achay Tucumachay Cercapuquio eCeCC caapu uioquio quio Overview Located in the Central Peru silver-lead-zinc metallogenic belt, the Mario Project represents a potential growth opportunity for the company. Through option agreements signed with Crocodile Gold Corp. in May of 2011 and with Consorcio Empresarial Agmin S.A.C. in July of 2011, Fortuna acquired an option to earn a 100% interest in combined 4,900 hectare property. Prior exploration of the property by Teck-Cominco Peru SA (1998-2000), Sulliden Exploration Inc. (2000- 2003) and Franc-Or Resources Corporation (2006-2008), identified significant ore-grade intercepts of silver-gold-lead-zinc mineralization associated with a late Tertiary diatreme breccia and intrusive dome complex. The combined program of Teck-Cominco, Sulliden and Franc-Or included project-scale mapping and sampling, geophysical surveys and approximately 14,000 meters of diamond drilling. Exploration and outlook In 2011, Fortuna completed detailed geologic mapping, geochemical sampling and detailed geophysical surveys in the Mario Project area. A 7,000 meter first phase drill program was initiated in November of 2011 and is projected for completion in April of 2012. The drill program will focus on the exploration and evaluation of disseminated gold-silver mineralization in the diatreme breccia as well as the testing of high- grade silver-lead-zinc replacement style deposits in limestone units in contact with the diatreme breccia. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 21 Drilling at Mario Property SILVER ANALYSIS Silver Price Monthly Average Comex Through April 16, 2012 2011 Silver Production by Country 774.9 million ounces z o / $ S U 45 40 35 30 25 20 15 10 5 0 Mexico 19.7% Peru 14.2% Other 37.7% United States 4.6% 75 79 83 87 91 95 99 03 07 11 Australia 7.2% China 16.6% E Source: CPM Group Source: CPM Group SILVER ANALYSIS Average price hits new high Silver prices averaged US$35.29 in 2011, up 73.8% from 2010 and a record nominal high, surpassing the annual average price of US$20.65 in 1980. In 2011 dollar terms, the average price of silver in 1980 was US$65.14. Silver prices continued to surge in the first few months of 2011, driven by momentum buying throughout the period. Prices dropped after peaking in April and trended lower for the remainder of the year. Silver demand, primarily from fabrication of consumer electronics and solar panels, helped boost demand overall as the global economy continued to expand. Higher mine output boosts supply Total silver supply rose to 995.1 million ounces, up 2.3% from 2010. Mine production accounted for the majority of the increase, rising 27.8 million ounces from 2010 levels. Mexico was the world’s largest producer silver in 2011. Mine output was a record 152.8 million ounces, up 18.8% from 128.6 million ounces in 2010. Peruvian silver output fell to 109.8 million ounces in 2011, from 116.9 million ounces in 2010. Much of the decline can be attributed to lower silver production at the largest silver producing mines in the country. Secondary supply of silver fell 1.2% year-over-year, totalling 277.1 million ounces in 2011. Secondary supply growth was curbed by a sharp drop in Indian scrap supplies, which fell to 4.8 million ounces, down two-thirds from 2010 levels. 22 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 0 SILVER ANALYSIS 2011 Total Fabrication Demand for Silver 861.9 million ounces Other Uses 21% Solar Panels 7% Electronics and Batteries 26% Photography 12% Jewelry and Silverware 34% Source: CPM Group Mobile devices containing silver boosted demand Economic expansion drives fabrication demand Fabrication demand for silver rose to 861.9 million ounces in 2011, a 2.2% increase from 843.5 million ounces in 2010. Fabrication demand increased as the global economy continued to expand, while demand from the photography sector again declined, as digital cameras commanded an ever larger market share. Silver used in consumer electronics rose, as healthy demand for mobile devices containing silver helped boost demand for the metal. Demand from the solar panel industry rose at a slower pace in 2011, up 23.1% to an estimated 59.8 million ounces, compared with nearly 100% growth in 2010. Higher prices slow investment demand Silver investment demand waned in 2011, which weighed heavily on prices after April. Some investors began exiting the silver market at this time, booking profits. Weaker economic growth in the second half of the year further contributed to investor disinterest in silver. Combined silver exchange traded product (ETP) holdings stood at 565.4 million ounces at the end of 2011. This was down 4.5% from 591.8 million ounces at the end of 2010, and the first annual decrease in holdings since the silver ETP was introduced in 2000. However, sales of US Mint Silver Eagle coins reached a record 39.9 million ounces in 2011, up 15.0% from a year ago. Outlook In 2012, fabrication demand for silver is forecast to rise further, but at a slower pace than in recent years. Healthy consumer and industrial demand is expected to continue, boosting industrial silver consumption, including that used in solar panels. Silver coin sales, however, may decline in 2012 from 2011 levels. Source: CPM Group FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 23 FINANCIAL REVIEW FINANCIAL REVIEW MANAGEMENT’S DISCUSSION & ANALYSIS Flotation at Caylloma Mine, Peru Business of the Company Recent Developments and 2011 Highlights Results of Operations Property Option Agreements Annual Financial Results page 25 26 27 32 33 35 Quarterly Information Fourth Quarter Financial Results 35 Cash Cost Per Silver Ounce and Cash Cost Per Tonne (non-GAAP financial measures) 37 Liquidity and Capital Resources 39 43 Off-Balance Sheet Arrangements 43 Derivatives 43 45 46 48 51 Other Data 54 54 Other Risks and Uncertainties 54 Controls and Procedures 54 Outlook 55 Related Party Transactions Significant Accounting Judgments and Estimates Financial Instruments and Related Risks Changes in Accounting Policies including Initial Adoption Cautionary Statement on Forward-Looking Statements International Financial Reporting Standards (“IFRS”) CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Chartered Accountants Consolidated Statements of Income Consolidated Statements of Comprehensive Income Consolidated Statements of Cash Flows Consolidated Statements of Financial Position Consolidated Statements of Changes in Equity 57 58 59 60 61 62 63 Notes to Consolidated Financial Statements 24 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS FOR THE YEAR ENDED DECEMBER 31, 2011 As at March 23, 2012 (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 ﬁnancial performance, this MD&A should be read in conjunction with the Company’s audited consolidated ﬁnancial statements for year ended December 31, 2011 and the related notes contained therein. The Company reports its ﬁnancial position, ﬁnancial performance and cash ﬂows in accordance with the International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). This MD&A refers to various non-GAAP ﬁnancial 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, income taxes, and interest income, 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, but do not have a standardized meaning and may differ from methods used by other companies with similar descriptions. The Company believes that certain investors use these non- GAAP ﬁnancial measures to evaluate the Company’s performance. Accordingly, non-GAAP ﬁnancial measures should not be considered in isolation or as a substitute for measures of performance prepared in accordance with IFRS. To facilitate a better understanding of these measures as calculated by the Company, we have provided detailed descriptions and reconciliations as required. This document contains forward-looking statements. Please refer to the cautionary language under the heading “Cautionary Statement on Forward-Looking Statements”. BUSINESS OF THE COMPANY Fortuna is engaged in silver mining and related activities, in Latin America, including exploration, extraction, and processing. The Company operates the Caylloma zinc/lead/silver mine in southern Peru and the San Jose silver/gold mine in Mexico. Fortuna is a publicly traded company incorporated and domiciled in Canada and is listed on the New York Stock Exchange under the trading ticker symbol “FSM”, and on the Toronto Stock Exchange and Lima Stock Exchange under the trading ticker symbol “FVI”. The Company’s registered ofﬁce is at Suite 650, 200 Burrard Street, Vancouver, British Columbia, Canada, V6C 3L6. The ﬁnancial results 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”); Fortuna Silver Mines Peru S.A.C. (“FSM Peru”); and Fortuna Silver Mexico, S.A. de CV. (“FS Mexico”). FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 25 MANAGEMENT’S DISCUSSION AND ANALYSIS RECENT DEVELOPMENTS AND 2011 HIGHLIGHTS FaTaL aCCidenT RePoRT It is with great sorrow the Company informs that on February 26, 2012 a fatal accident claimed the life of a driller and injured a supervisor, both working for the Company’s mine contractor operating the Animas vein on Level 12 of the Caylloma mine. All mine operations were stopped immediately. The supervisor is in stable condition and recovering in a hospital in Arequipa. Mine operations resumed on February 28, 2012. Fortuna’s senior operations management team traveled to the mine site the same day of the accident and a corporate investigation of this tragic accident was launched. Findings indicate the crew of contractors suffered a premature detonation on a round of rib and ditch blast. Levels of responsibility and breaches of safety regulations and procedures that led to the accident were identiﬁed as a result of the investigation. Under the recommendations of the investigation report, Fortuna is implementing companywide measures to ensure additional safeguards are in place against violations of safety regulations and procedures. This is the ﬁrst tragic accident in the history of Fortuna’s operations. The Company has a culture of zero tolerance for insecure acts and conditions and is acting accordingly. FinanCiaL and oPeRaTing ReSuLTS During the quarter ended December 31, 2011, the Company generated a net loss of $1.76 million (Q4 2010: income $4.33 million) on operating income of $4.44 million (Q4 2010: $8.03 million) and sales of $31.05 million (Q4 2010: $23.91 million). During the year ended December 31, 2011, the Company generated a net income of $19.53 million (2010: income $16.00 million) on operating income of $38.07 million (2010: $27.73 million) and sales of $110.00 million (2010: $74.06 million). Silver ounces produced during the quarter ended December 31, 2011 were 913,803 (Q4 2010: 481,802) ounces, 90% above the prior year. Gold ounces produced during the quarter ended December 31, 2011 were 4,153 (Q4 2010: 1,822) ounces, 128% above the prior year. Silver ounces produced during the year ended December 31, 2011 were 2,486,655 (2010: 1,906,423) ounces, 30% above the prior year. Gold ounces produced during the year ended December 31, 2011 were 6,843 (2010: 2,556) ounces, 168% above the prior year. During the quarter ended December 31, 2011 silver comprised 68% (Q4 2010: 55%) of revenue and the realized silver price was $27.64 (Q4 2010: $23.73) per ounce. San Jose contributed to our consolidated revenue stream for the full quarter after commencing operations in September 2011. As at the end of 2011, San Jose had accumulated approximately $4.4 million worth of silver-gold concentrate inventory based on average prices for the quarter. Consolidated cash cost per ounce, for the quarter, net of by-product credits, was $5.11 (Q4 2010: negative $6.31). Refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales. During the year ended December 31, 2011 silver comprised 65% (2010: 49%) of revenue and the realized silver price was $31.11 (2010: $18.18) per ounce. Consolidated cash cost per ounce, for the year, net of by-product credits, was $0.37 (2010: negative $5.99). Refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales. Cash generated by operating activities before changes in working capital, income taxes, and interest income for the year ended December 31, 2011 totalled $53.35 million, up from $31.34 million in 2010. Commercial production at the San Jose silver and gold mine was delivered on September 1, 2011 on-time and on-budget after ﬁfteen months of construction and commissioning. The mine and mill are operating within design parameters at a rate of 1,000 tpd with a planned investment in infrastructure, in 2012 and 2013, to expand to 1,500 tpd by Q3 2013. Cash cost per Ag oz, net of by-product credits, for 2011 was $4.51. CoRPoRaTe HigHLigHTS On April 19, 2011 the Company announced changes to the Board of Directors with the appointment of Mr. Thomas Kelly and the resignation of Mr. Jeffrey Franzen. On May 26, 2011 Mr. Jorge Ganoza Aicardi resigned as Vice-President, Operations. Effective August 1, 2011 Mr. Manuel Ruiz-Conejo, previously Vice-President, Project Development was appointed to the position. The Company’s common shares began trading on the New York Stock Exchange (“NYSE”) at the opening of trading on Monday, September 19, 2011 (refer to Sedar.com for releases dated August 29, 2011 and September 15, 2011). Effective at the market open on December 19, 2011, the Company was added to the S&P/TSX Composite. 26 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS ConSoLidaTed MeTaL PRoduCTion Consolidated Metal Production Silver (Oz)* Gold (Oz)* Lead (000’s lb) Zinc (000’s lb) Copper (000’s lb) QuaRTeRLy ReSuLTS Three months ended december 31, 2011 2010 yeaR To daTe ReSuLTS years ended december 31, 2011 2010 913,803 4,153 4,396 5,688 0 481,802 1,822 5,338 6,158 987 2,486,655 6,843 19,678 23,425 36 1,906,423 2,556 21,373 26,137 4,596 * Caylloma: Silver in lead and copper concentrates; San Jose: Silver in silver and gold concentrates. The Company’s silver production in Q4 of 2011 was 90% higher than Q4 2010 as a result of higher silver production from Caylloma of 11% and the contribution from San Jose for its ﬁrst full quarter under commercial operations. The Company’s silver production in 2011 was 30% higher than in 2010 as a result of higher silver production from Caylloma of 5% and the contribution from San Jose for the second half of the year. ConSoLidaTed PRoduCTion HigHLigHTS FoR Q4 2011: • Silver production of 913,803 ounces; 90% increase over Q4 2010; • Gold production of 4,153 ounces; 128% increase over Q4 2010; • Lead production of 4,396 (000’s) pounds; 18% decrease over Q4 2010, and, • Zinc production of 5,688 (000’s) pounds; 8% decrease over Q4 2010. ConSoLidaTed PRoduCTion HigHLigHTS FoR 2011: • Silver production of 2.49 million ounces; 30% increase over 2010; • Gold production of 6,843 ounces; 168% increase over 2010; • Lead production of 19,678 (000’s) pounds; 8% decrease over 2010, and, • Zinc production of 23,425 (000’s) pounds; 10% decrease over 2010. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 27 MANAGEMENT’S DISCUSSION AND ANALYSIS CayLLoMa Mine PRoduCTion Mine Production Silver* Grade (g/t) Recovery %* Production (Oz)* gold 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 QuaRTeRLy ReSuLTS Three months ended december 31, 2011 2010 yeaR To daTe ReSuLTS years ended december 31, 2011 2010 177.42 80.82 536,426 159.51 83.69 481,802 170.91 81.43 2,008,488 159.24 85.67 1,906,423 0.35 44.97 591 1.85 92.39 4,396 2.47 89.73 5,688 0.40 51.00 734 2.37 90.93 5,338 2.87 86.77 6,158 0.36 45.71 2,393 2.15 92.68 19,678 2.68 88.46 23,425 0.40 46.28 2,556 2.44 91.28 21,373 3.10 87.99 26,137 0 987 36 4,596 Production cash cost (US$/oz ag)** Production cash cost (US$/tonne) Unit Net Smelter Return (US$/tonne) 6.67 79.68 188.42 (6.31) 64.55 185.96 (0.59) 68.98 217.70 (5.99) 58.43 163.59 * Caylloma: Silver in lead and copper concentrates. ** Net of by-product credits. SuMMaRy oF Q4 2011 CayLLoMa Mine PRoduCTion ReSuLTS: • Silver production of 536,426 ounces; 11% increase over Q4 2010; • Gold production of 591 ounces; 68% decrease over Q4 2010; • Lead production of 4,396 (‘000’s) pounds; 18% decrease over Q4 2010; • Zinc production of 5,688 (‘000’s) pounds, 8% decrease over Q4 2010; and, • Cash cost per silver ounce, net of by-product credits, $6.67 (refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales). SuMMaRy oF 2011 CayLLoMa Mine PRoduCTion ReSuLTS: • Silver production of 2,008,488 ounces; 5% increase over 2010; • Gold production of 2,319 ounces; 9% decrease over 2010; • Lead production of 19,678 (‘000’s) pounds; 8% decrease over 2010; • Zinc production of 23,425 (‘000’s) pounds; 10% decrease over 2010; and, • Cash cost per silver ounce, net of by-product credits, negative $0.59 (refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales). 28 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS diSCuSSion on CayLLoMa Mine oPeRaTionS Silver production at Caylloma for the year was 2,008,488 ounces with mill feed being sourced mainly from the Animas (88%), Bateas (6%), and Soledad (5%) veins. The increase in silver production for the year compared to the same period last year was achieved through higher throughput and head grades in spite of a decrease in metallurgical recovery rates of 5%. Higher grades are a result of an increase in mill feed contribution from the high silver grade ore shoot on level 6 in Animas vein and bonanza ore from Bateas vein. The reduction in metallurgical recoveries is a result of mixed sulﬁde- oxide material on level 6 of the Animas vein. In January 2011, production of copper-silver concentrate was discontinued at Caylloma due to a material deterioration in treatment and reﬁning smelter charges with respect to 2010. The Company is monitoring market conditions to evaluate restarting the circuit. Copper accounted for 0.18% of sales in 2011 (2010: 3.68%). The new high-grade silver ore shoots that were discovered through the extension of exploration and development drifts from current production areas on the 10th and 12th levels of the Bateas Vein (refer to press release dated April 14, 2011) entered into production in late June. Exploration drifting towards the northeast area of the Bateas Vein was stopped by the end of September 2011 in order to improve ventilation and infrastructure for auxiliary services in levels 10 and 12. By mid December 2011, a ventilation shaft from surface to level 12 was completed, and two more shafts between levels 10 and 12 should be completed by the end of March 2012 to resume exploration drifting. In June 2011, the Company received the approval of the environmental impact study for the construction of a plant expansion to 1,500 tpd encompassing a new tailings facility. The construction of the tailings dam for the ﬁrst two years of operation concluded in late 2011. The tailings pipeline and pumping system is scheduled for completion in June 2012. Total design capacity of the tailings facility including future expansions is for 9 years of operation at the current mill throughput rate. In May 2011, the Company submitted to the Ministry of Energy and Mines (“MEM”), in Peru, the application for construction permit of the tailings facility. Approval of this permit has not been received as of March 23, 2012. All technical and surface rights observations made by MEM in November 2011 have been addressed and the Company is awaiting ﬁnal resolution. Although the Company is working closely with MEM and expects to receive the permits on time, the delay in obtaining this permit represents a risk for the commissioning of the new tailings facility in June 2012 which could lead to a subsequent temporary stoppage of operations. Cash cost per payable ounce of silver, for the year ended December 31, 2011, was negative $0.59 net of by-product credits compared to negative $5.99 in 2010. This increment was driven by a cash cost increase and lower base metal credits in the second half of 2011, with special emphasis in the fourth quarter. Cash cost per oz throughout 2011 went from negative $5.82 in Q1 2011 to $6.67 in Q4 2011. The sharp increment throughout the year is explained by a decrease in by-product credits of $9.40/oz and a 29% unit cash cost per tonne increase. The decrease in by-product credits was primarily due to lower base metal prices (lead 24%, zinc 21%) and lower lead production (13%). The unit cost increments reﬂect cost increases in qualiﬁed labor and industry related services that have been mounting in the Peruvian underground mining industry since late 2010. For 2012, the Company anticipates cost pressures to continue; several productivity and cost control initiatives are included in the 2012 operational and capital budgets. Capital expenditures for the year ended December 31, 2011 amounted to $17.1 million. The main components were the ﬁrst phase of the new tailings facility ($7.8 million), mine development ($3.7 million), and camp infrastructure and ancillary facilities ($1.7 million). Capital expenditures budgeted for the year 2012 amount to $25.1 million which includes the second phase of the new tailings facility ($4.8 million), upgrading of the processing plant ($8.2 million), mine camp improvements ($4.8 million), and mine development ($4.5 million). A total of 10,551 meters were drilled in Caylloma in 2011 with close to 50% of the program allocated to Animas vein and the other 50% distributed among high grade silver targets at La Plata, San Cristobal, and Bateas veins. A total of 3,642 meters of exploration drifting were done with 50% allocated to Bateas and San Cristobal veins, and 40% allocated to Animas vein. The brownﬁelds exploration budget for 2012, amounts to $7.2 million including 3,552 meters of drifting and 16,000 meters of drilling. Cash cost is a non-GAAP ﬁnancial measure, refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 29 MANAGEMENT’S DISCUSSION AND ANALYSIS San joSe Mine PRoduCTion*** QuaRTeRLy ReSuLTS Three months ended december 31, Mine Production Tonnes milled average tons milled per day Silver* Grade (g/t) Recovery %* Production (Oz)* gold Grade (g/t) Recovery %* Production (Oz)* unit Costs Production cash cost (US$/oz ag)** Production cash cost (US$/tonne) Unit Net Smelter Return (US$/tonne) 2011 87,884 955 159.00 84.00 377,377 1.48 84.90 3,562 2.85 47.16 147.31 * San Jose: Silver in silver gold concentrates. ** Net of by-product credits. *** From commercial production, which commenced on September 1, 2011. SuMMaRy oF Q4 2011 San joSe Mine PRoduCTion ReSuLTS: • Silver production of 377,377 ounces; • Gold production of 3,562 ounces; and, 2010 0 0 0.00 0.00 0 0.00 0.00 0 na na 0.00 yeaR To daTe ReSuLTS years ended december 31, 2011 2010 116,410 954 150.40 84.95 478,167 1.43 84.62 4,524 4.51 50.73 147.33 0 0 0.00 0.00 0 0.00 0.00 0 na na 0.00 • Cash cost per silver ounce, net of by-product credits, $2.85 (refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales). SuMMaRy oF 2011 San joSe Mine PRoduCTion ReSuLTS: • Silver production of 478,167 ounces; • Gold production of 4,524 ounces; and, • Cash cost per silver ounce, net of by-product credits, $4.51 (refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales). diSCuSSion on San joSe Mine oPeRaTionS Production at the San Jose silver and gold mine commenced on September 1, 2011 on-time and on-budget after ﬁfteen months of construction and commissioning. The mine and mill are operating within design parameters at a rate of 1,000 tpd with a planned investment in infrastructure, in 2012 and 2013, to expand to 1,500 tpd by Q3 2013. Cash cost per tonne of processed ore was $50.73. Mine production is currently taking place above level 1,400 on blocks K, L, and M with production targets being met according to plan. Production in level 1,300 is scheduled to commence during the second quarter of 2012, 3 months ahead of the original mine plan. As of the end of the second week of March 2012, the main ramp reached the 1,300 meter elevation where production blocks C and D will be developed by year end as the mine moves towards the planned expansion of 1,500 tpd. The plant is processing ore at an average throughput rate of 1,000 tpd. Metallurgical recovery is still undergoing an adjustment process and remains within 95% of design parameters. Concentrate grade is already at planned levels for the current head grades. Capital expenditures budgeted for the year 2012, amounts to $30.7 million which includes a new concentrate leaching facility to produce dore bars ($12 million), ramp and mine development ($9.2 million), tailings dam expansion to support 1,500 tpd ($4.5 million), processing plant expansion ($1.6 million), a hydraulic ﬁll plant and the underground power grid ($2.6 million). 30 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS A total of 13,527 meters were drilled in San Jose and our surrounding properties in 2011 with 60% of the program directed to test the southern extension of the San Jose deposit (“San Ignacio”) and the balance allocated to new target zones Taviche and El Rancho. A follow up program for San Ignacio in 2012 will continue testing for extensions of mineralization open to the south of existing reserves. The 2012 brownﬁelds program amounts to $5.8 million including over 15,000 meters of drilling. Violent acts have claimed the life of two members of the San Jose del Progreso community on January 18 and March 15, 2012. These murders are being investigated by local authorities and mourned by the entire community. Continuous violence in Mexico and in the state of Oaxaca is a concern for the Company. Security measures are being taken to ensure the safeguard of our personnel. Cash cost, cash cost per silver ounce, and cash cost per tonne are non-GAAP ﬁnancial measures, refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures) for reconciliation of cash cost to the cost of sales. CayLLoMa Mine and San joSe Mine* ConCenTRaTeS Mine Concentrates Caylloma San jose Caylloma San jose Caylloma San jose Caylloma San jose QuaRTeRLy ReSuLTS Three months ended december 31, yeaR To daTe ReSuLTS years ended december 31, 2011 2010 2011 2010 Silver gold Opening Inventory (t) Production (t) Sales (t) Adjustment (t) Closing Inventory (t) Ag in concentrate (g/t)** Au in concentrate (g/t)** Zinc Opening Inventory (t) Production (t) Sales (t) Adjustment (t) Closing Inventory (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 (%)** 0 0 0 0 0 0 0 538 2,276 2,084 0 730 5,155 49 273 4,964 4,920 -12 305 51.98 232 3,599 3,590 14 255 4,636 55.41 4 0 0 0 4 0 0.00 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0 540 5,467 5,749 5 263 51.09 404 3,829 4,053 8 188 1,685 63.23 44 448 464 1 29 19,056 21.62 0 0 0 0 0 0 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0 0 2,958 2,227 0 730 5,028 48 263 20,569 20,490 -37 305 51.66 188 15,767 15,760 60 255 3,881 56.61 29 80 104 -1 4 15,876 20.23 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0 369 22,291 22,419 22 263 53.86 408 15,015 15,250 14 188 1,499 64.56 46 2,085 2,117 15 29 17,644 22.31 0 0 0 0 0 0 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 0 0 0 0 0 0 0.00 * Commercial production commenced on September 1, 2011. ** Grades from commercial production. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 31 MANAGEMENT’S DISCUSSION AND ANALYSIS PROPERTY OPTION AGREEMENTS MaRio PRoPeRTy In May 2011, the Company entered into an agreement to acquire a 100% interest in the Mario Property, located in the Department of Junin in central Peru. Under the terms of the agreement, the Company is granted the exclusive right and option to purchase an undivided 100% interest in the Mario Property subject to the following payments: 1. $0.50 million on signing of agreement; 2. $0.50 million on or before six months from the signing of the agreement; 3. $0.50 million on or before 12 months from the signing of the agreement; and, 4. $2.50 million on or before 24 months from the signing of the agreement. The transfer of the property to the Company is subject to a 1% net smelter return (“NSR”) royalty on production from the property payable to Crocodile Gold (“Crocodile”). The Company shall have the right to purchase the NSR royalty from Crocodile at any time during the ﬁve-year period following the ﬁnal option payment for the sum of $3.0 million. The property is also subject to a 2% NSR royalty on production payable to Teck Cominco and a 0.5% NSR royalty on production payable to Socrate Capital Inc., with each royalty in turn subject to certain buy-back provisions. As at December 31, 2011, $1.0 million has been paid under the agreement. don MaRio PRoPeRTy The Company entered into an option agreement, effective July 20, 2011, to acquire 100% interest in the Don Mario property, with Consorcio Empresarial Agmin S.A.C.(“AGMIN”). Under the terms of the mining assignment and option to purchase mineral rights agreement (“agreement”), the Company is required to make the following payments: 1. $0.20 million on signing the agreement; 2. $0.30 million after 12 months from signing the agreement; 3. $0.50 million after 24 months from signing the agreement; and, 4. $2.00 million after 36 months from signing the agreement. Under the terms of the agreement, once the option is exercised and technical report is prepared under National Instrument 43-101 and published, if the pre-feasibility study indicates that the property contains more than ﬁve million silver equivalent ounces, the Company would further pay AGMIN, one dollar for each additional resource and reserves indicated in the pre-feasibility report. The Company has the option to buy-out the additional pay-out for a further $3.0 million, subject to certain conditions. As at December 31, 2011, $0.20 million has been paid under the agreement. 32 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS ANNUAL FINANCIAL RESULTS expressed in $000's, except per share data*/** Sales Operating income Income Earnings per share, basic Earnings per share, diluted Total assets Leases and long term liabilities 2011* 110,004 38,065 19,533 0.16 0.16 271,606 2,764 years ended december 31, 2010* 74,056 27,728 16,003 0.15 0.14 233,870 3,166 2009** 51,428 14,383 623 0.01 0.01 139,738 1,454 * Figures for 2011 and 2010 expressed under IFRS. ** Figures for 2009 expressed under Canadian Generally Accepted Accounting Principles ("CAD GAAP"). The comparative ﬁnancial information for 2009 is presented in accordance with Canadian Generally Accepted Accounting Principles (“CAD GAAP”) and was not required to be restated to IFRS in this MD&A. During the year ended December 31, 2011 the Company generated net income of $19.53 million (2010: $16.00 million) on operating income of $38.07 million (2010: $27.73 million). The increase in net income is mainly attributable to higher mine operating income of $60.97 million (2010: $39.21 million) driven by higher sales at Caylloma and the contribution of the San Jose mine, offset by higher selling, general and administrative expenses of $19.84 million (2010: $10.98 million), income taxes of $18.80 million (2010: $11.51 million), impairment of mineral properties, property, plant and equipment of $1.89 million (2010: $nil), exploration and evaluation costs of $1.72 million (2010: $0.55 million), and lower gain on commodity contracts of $0.48 million (2010: $0.74 million). Sales, for the year end December 31, 2011, increased by 49% to $110.00 million (2010: $74.06 million), compared to the prior year. The sales increase is mainly a result of higher realized prices for silver, gold, lead and zinc of 71%, 29%, 9% and 9%, respectively, and higher metals sold for silver and gold of 23% and 124%, respectively, offset by lower metal sold for lead and zinc of 8% and 11%, respectively. Mine MeTaL SoLd and PRiCeS 2011 yeaR To daTe ReSuLTS years ended december 31, 2010 Mine Metal Sold and Prices Caylloma San jose Consolidated Caylloma San jose Consolidated Silver Sales (Oz)* Net Realized Price (US$/Oz)** 2,004,457 31.91 320,599 2,325,056 31.11 26.42 1,894,703 18.18 gold Sales (Oz)* Net Realized Price (US$/Oz)** 2,438 1,116.09 2,952 1,230.34 5,391 1,183.39 Lead Sales (000’s lb)* Net Realized Price (US$/lb)** Zinc Sales (000’s lb)* Net Realized Price (US$/lb)** Copper Sales (000’s lb)* Net Realized Price (US$/lb)** 19,685 0.86 23,323 0.66 52 2.65 – – – – – – 19,685 0.86 23,323 0.66 52 2.65 2 ,411 920.85 21,461 0.79 26,306 0.60 1,021 2.60 – – – – – – – – – – 1,894,703 18.18 2,411 920.85 21,461 0.79 26,306 0.60 1,021 2.60 * Contained metal in concentrate. The current and subsequent period may include ﬁnal settlement quantity adjustments from prior periods. ** Calculated based on contained metals and after deductions, treatment, and reﬁning charges. Treatment charges are allocated to the base metals in Caylloma and to gold in San Jose. Net realized prices are based on provisional sales and are calculated before governmental royalties. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 33 MANAGEMENT’S DISCUSSION AND ANALYSIS Cost of sales, for the year ended December 31, 2011, increased by 41% to $49.03 million (2010: $34.84 million) compared to the prior year. The increase is primarily attributable to 18% higher unit production cash costs per tonne of processed ore in Caylloma and an overall throughput increase of 30%. The higher unit production cash cost per tonne of processed ore reﬂect cost increases in qualiﬁed labor and industry related services that have been mounting in the Peruvian underground mining industry since late 2010. (Refer to cash cost per silver ounce and cash cost per tonne (non-GAAP ﬁnancial measures), discussion on Caylloma mine operations, and discussion on San Jose mine operations). Selling, general and administrative expenses, for the year ended December 31, 2011, increased by 81% to $19.84 million (2010: $10.98 million). The increase is primarily attributable to share-based payments of $4.79 million in 2011 compared to a net recovery of $0.42 million in 2010, a $2.61 million increase in corporate general and administrative expenses mainly as a result of higher salaries and professional fees related to the growth of the company, the New York Stock Exchange (“NYSE”) listing, and $0.87 million from Cuzcatlan as a result of the commencement of commercial production in the second half of 2011. Corporate general and administrative expenses Bateas general and administrative expenses Cuzcatlan general and administrative expenses Foreign exchange Share-based payments Peruvian workers’ participation $ expressed in $ millions year ended december 31, $ 2011 9.97 3.36 0.87 0.22 4.79 0.63 2010 7.36 3.83 – 0.21 (0.42) – $ 19.84 $ 10.98 exploration and evaluation costs, for the year ended December 31, 2011, increased to $1.72 million (2010: $0.55 million) as the Company pursues its exploration program. impairment of mineral properties, property, plant and equipment, for year ended December 31, 2011, amounted to $1.89 million (2010: $nil) as the Company has taken an impairment charge related to the Taviche property comprised of: $1.08 million on the tailing dam, $0.14 million on the mine infrastructure, and $0.67 million on equipment, machinery, and buildings. In 2010, the Company included the idle plant in Taviche as part of the San Jose mine plant as it was more likely than not that the idle plant could be used to treat excess ore from San Jose or from surrounding areas where the company was conducting exploration. On September 1, 2011, the San Jose mine plant commenced commercial production and in the fourth quarter of 2011, achieved an average of 955 tonnes milled per day with the San Jose plant having sufﬁcient capacity for the production. In the fourth quarter, management reassessed the usability of the idle plant and in conjunction, obtained an independent third party appraisal of various assets acquired under an asset purchase agreement dated 2007 related to the Taviche property. Management used the fair value less cost to sell method to determine the recoverable amount of the idle plant. Based upon an independent appraisal of the assets, which is in accordance with fair value less cost to sell, the Company has taken an impairment charge of $1.89 million that comprised of the following impairments: $1.08 million on the tailing dam, $0.14 million on the mine infrastructure, and $0.67 million on equipment, machinery, and buildings. As at December 31, 2011, the net book value of assets related to the Taviche property for machinery, and equipment amount to $0.36 million. net gain on commodity contract, for the year ended December 31, 2011, was $0.48 million (2010: $0.74 million). The gain is related to short term contracts used to ﬁx the ﬁnal settlement price on metal contained in concentrate delivered throughout the period. interest income, for the year ended December 31, 2011, increased by 68% to $0.83 million (2010: $0.49 million). The increase in interest income is primarily attributable to interest earned on long term receivables through the sale of assets and higher invested cash balances at the ﬁrst half of the year. interest expense, for the year ended December 31, 2011, decreased by 21% to $0.56 million (2010: $0.71 million) as a result of a reduction in standby and commitment fees, compared to the prior year. income taxes, for the year ended December 31, 2011, increased by 63% to $18.80 million (2010: $11.51 million) due to higher income recorded at Bateas and deferred tax arising from Cuzcatlan. Income tax provision is comprised of $14.61 million of current income tax expense and $4.19 million of deferred income tax expense mainly related to our Peruvian and Mexican operations. 34 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS QUARTERLY INFORMATION The following table provides information for the eight ﬁscal quarters ended December 31, 2011: expressed in $000's, except per share data* 31-dec-11 30-Sep-11 30-jun-11 31-Mar-11 31-dec-10 30-Sep-10 30-jun-10 31-Mar-10 Quarters ended Sales Operating income Income before taxes Income (loss) Earnings per share, basic Earnings per share, diluted Total assets Leases and long term liabilities 31,047 4,437 4,443 (1,755) (0.01) (0.01) 32,543 14,886 14,948 10,309 0.08 0.08 24,528 10,665 10,754 6,197 0.05 0.05 21,886 8,077 8,190 4,782 0.04 0.04 23,909 8,031 8,033 4,333 0.04 0.04 18,039 1,030 780 (773) (0.01) (0.01) 14,565 9,629 9,666 6,719 0.06 0.06 17,543 9,038 9,034 5,724 0.06 0.05 271,606 270,259 253,287 242,564 233,870 180,473 175,445 170,198 1,306 2,764 2,988 3,384 3,166 2,653 1,384 2,873 * Figures for 2011 and 2010 expressed under IFRS. The past eight quarters show a consistent trend of sales growth with a marginal decline in Q4 2011 from Q3 2011. This trend reﬂects the surge in silver price since the beginning of 2010 and the commencement of commercial production at the San Jose mine starting in September 2011. FOURTH QUARTER FINANCIAL RESULTS expressed in $’000’s Sales Cost of sales Mine operating income other expenses Selling, general and administrative expenses Exploration and evaluation costs Net gain on commodity contracts Loss on disposal of mineral properties, property, plant and equipment Loss on disposal of investment Write-off of deferred exploration costs Impairment of mineral properties, property, plant and equipment operating income Finance items Interest income Interest expense net ﬁnance income income before tax Income taxes Three months ended december 31, $ 2011 31,047 17,782 13,265 $ 2010 23,909 9,804 14,105 5,871 605 442 16 – – 1,894 4,437 155 (149) 6 4,443 6,198 4,583 202 725 2 119 443 – 8,031 159 (157) 2 8,033 3,700 (Loss) income for the period $ (1,755) $ 4,333 During the fourth quarter ended December 31, 2011 the Company generated net loss of $1.76 million (Q4 2010: $4.33 million) on operating income of $4.44 million (Q4 2010: $8.03 million). The decrease in net income compared to the same period in 2010 is mainly attributable to lower mine operating income of $13.27 million (Q4 2010: $14.11 million), higher selling, general and administrative expenses of $5.87 million (Q4 2010: $4.58 million), impairment of mineral properties, property, plant and equipment of $1.89 million (Q4 2010: $nil), exploration and evaluation costs of $0.61 million (Q4 2010: $0.20 million), and income taxes of $6.20 million (Q4 2010: $3.70 million). The decrease in mine operating income in spite of the contribution from the San Jose mine in 2011 and a higher silver price is explained by lower revenue from base metals of $4 million, negative price adjustments in Caylloma associated with the sharp fall in silver price in the fourth quarter, and higher unit costs of 23% at Caylloma. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 35 MANAGEMENT’S DISCUSSION AND ANALYSIS Sales, for the fourth quarter ended December 31, 2011 increased by 30% to $31.05 million (Q4 2010: $23.91 million) compared to the same quarter a year ago with San Jose contributing $11.39 million (Q4 2010: $nil). Sales at Caylloma decreased by 18% to $19.66 (Q4 2010: $23.91), in spite of higher silver prices (20%) and higher silver sold (11%), mainly due to lower lead and zinc sold (22% and 13% respectively) with lower lead and zinc prices (23% and 15%, respectively) representing $4.25 million of decreased revenue, and a negative ﬁnal sales adjustments of $2.33 million (Q4 2010: positive $1.85 million) associated with the sharp fall in silver price in the quarter. Mine MeTaL SoLd and PRiCeS QuaRTeRLy ReSuLTS Three months ended december 31, 2011 2010 Mine Metal Sold and Prices Caylloma San jose Consolidated Caylloma San jose Consolidated Silver Sales (Oz)* Net Realized Price (US$/Oz)** 547,542 28.58 300,411 26.08 847,952 27.64 494,451 23.73 gold Sales (Oz)* Net Realized Price (US$/Oz)** Lead Sales (000's lb)* Net Realized Price (US$/lb)** Zinc Sales (000's lb)* Net Realized Price (US$/lb)** Copper Sales (000's lb)* Net Realized Price (US$/lb)** 597 1,245.14 2,770 1,227.19 3,367 1,229.99 696 1,031.09 4,385 0.67 5,613 0.54 – – – – – – – – 4,385 0.67 5,613 0.54 – – 5,605 0.87 6,487 0.64 221 3.07 – – – – – – – – – – 494,451 23.73 696 1,031.09 5,605 0.87 6,487 0.64 221 3.07 * Contained metal in concentrate. The current and subsequent period may include ﬁnal settlement quantity adjustments from prior periods. ** Calculated based on contained metals and after deductions, treatment, and reﬁning charges. Treatment charges are allocated to the base metals in Caylloma and to gold in San Jose. Net realized prices are based on provisional sales and are calculated before governmental royalties. Cost of sales, for the fourth quarter ended December 31, 2011 increased by 81% to $17.78 million (Q4 2010: $9.80 million) compared to the prior year. The increase is primarily attributable to the contribution of the San Jose mine which was in production for the full quarter resulting in an overall throughput increase of 82%, and to 23% higher unit production cash costs per tonne of processed ore at Caylloma (Refer to cash cost per silver ounce and cash cost per tonne (non- GAAP ﬁnancial measures)). Selling, general and administrative expenses, for the fourth quarter ended December 31, 2011 increased by 28% to $5.87 million (Q4 2010: $4.58 million). The increase is primarily attributable to share-based payments of $1.20 million (Q4 2010: $0.76 million), a $0.75 million increase in corporate general and administrative expenses, mainly as a result of higher salaries and professional fees related to the growth of the Company, and $0.67 million from Cuzcatlan (Q4 2010: $nil). Corporate general and administrative expenses Bateas general and administrative expenses Cuzcatlan general and administrative expenses Foreign exchange Share-based payments Peruvian workers’ participation expressed in $ millions Three months ended december 31, 2011 2.90 0.82 0.67 0.19 1.20 0.09 5.87 $ $ 2010 2.15 1.50 – 0.17 0.76 – 4.58 $ $ exploration and evaluation costs, for the fourth quarter ended December 31, 2011 increased to $0.61 million (Q4 2010: $0.20 million) as the Company pursues its exploration program. 36 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS impairment of mineral properties, property, plant and equipment, for the fourth quarter ended December 31, 2011, amounted to $1.89 million (Q4 2010: $nil) as the Company has taken an impairment charge related to the Taviche property comprised of: $1.08 million on the tailing dam, $0.14 million on the mine infrastructure, and $0.67 million on equipment, machinery, and buildings. net loss on commodity contract, for the fourth quarter ended December 31, 2011, was $0.44 million (Q4 2010: $0.73 million). The loss is related to short term contracts used to ﬁx the ﬁnal settlement price on metal contained in concentrate delivered throughout the period. interest income, for the fourth quarter ended December 31, 2011 decreased by 3% to $0.16 million (Q4 2010: $0.16 million) as a result of a reduction in cash balances. interest expense, for the fourth quarter ended December 31, 2011 decreased by 5% to $0.15 million (Q4 2010: $0.16 million) as a result of a reduction in the balance of ﬁnance leases. income taxes, for the fourth quarter ended December 31, 2011 increased by 68% to $6.20 million (Q4 2010: $3.70 million) due to higher recorded income at Bateas and deferred tax arising from Cuzcatlan. CASH COST PER SILVER OUNCE AND CASH COST PER TONNE (NON-GAAP FINANCIAL 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 but do not have a standardized meaning and may differ from methods used by other companies with similar descriptions. Management believes that certain investors use these non-GAAP ﬁnancial measures to evaluate the Company’s performance. These performance measures have no meaning under International Financial Reporting Standards (“IFRS”) 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 ﬁnancial statements for the three months and years ended December 31, 2011 and 2010. ConSoLidaTed Mine CaSH CoST Consolidated Mine Cash Cost Cost of sales 2, 3 Add/(Subtract) Change in concentrate inventory Depletion and depreciation in concentrate inventory Inventory adjustment Government royalties and mining taxes Workers participation Depletion and depreciation 2 Cash cost Total processed ore (tonnes) expressed in $000’s expressed in $000’s Q4 2011 17,782 yTd Q4 2011 49,030 Q4 2010 9,804 yTd Q4 2010 34,844 415 2,142 (295) (305) (207) – (385) (436) (3,752) 13,417 204,248 (781) – (1,322) (3,141) (9,060) 36,868 565,276 65.22 124 525 (320) (881) (1,711) 7,246 112,257 64.55 7,246 (10,544) 410 (2,888) 5 290 (788) (2,320) (6,327) 25,399 434,656 58.43 25,399 (37,825) 1,576 (10,850) Cash cost per tonne of processed ore ($/t) 65.69 Cash cost Add/(Subtract) By-product credits 1 Reﬁning charges Cash cost applicable per payable ounce 13,417 36,868 (11,252) 2,234 4,399 (40,267) 4,280 881 Payable silver ounces 860,565 2,352,759 457,712 1,811,102 Cash cost per ounce of payable silver ($/oz) 5.11 0.37 (6.31) (5.99) 1 By-product credits as included in the provisional sales. 2 2010 and 2011 ﬁgures in accordance with IFRS. 3 Includes depletion, depreciation, distribution, community relations, government royalties and mining taxes, and workers participation. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 37 MANAGEMENT’S DISCUSSION AND ANALYSIS CayLLoMa Mine CaSH CoST Caylloma Mine Cash Cost Cost of sales 2, 3 Add/(Subtract) Change in concentrate inventory Depletion and depreciation in concentrate inventory Government royalties and mining taxes Workers participation Depletion and depreciation 2 Cash cost Total processed ore (tonnes) Cash cost per tonne of processed ore ($/t) Cash cost Add/(Subtract) By-product credits 1 Reﬁning charges Cash cost applicable per payable ounce expressed in $000’s expressed in $000’s Q4 2011 11,777 yTd Q4 2011 42,236 Q4 2010 9,804 yTd Q4 2010 34,844 92 206 (295) (305) (12) (385) (436) (1,764) 9,272 116,363 79.68 9,272 (6,773) 900 3,399 (97) (1,322) (3,141) (6,919) 30,963 448,866 68.98 30,963 (34,676) 2,590 (1,123) 124 (320) (881) (1,711) 7,246 112,257 64.55 7,246 (10,544) 410 (2,888) 5 (788) (2,320) (6,327) 25,399 434,656 58.43 25,399 (37,825) 1,576 (10,850) Payable silver ounces 509,605 1,908,064 457,712 1,811,102 Cash cost per ounce of payable silver ($/oz) 6.67 (0.59) (6.31) (5.99) 1 By-product credits as included in the provisional sales. 2 2010 and 2011 ﬁgures in accordance with IFRS. 3 Includes depletion, depreciation, distribution, community relations, government royalties and mining taxes, and workers participation. San joSe Mine CaSH CoST San jose Mine Cash Cost Cost of sales 2, 3 Add/(Subtract) Change in concentrate inventory Depletion and depreciation in concentrate inventory Depletion and depreciation 2 Cash cost Total processed ore (tonnes) Cash cost per tonne of processed ore ($/t) Cash cost Add/(Subtract) By-product credits 1 Reﬁning charges Cash cost applicable per payable ounce expressed in $000’s Q4 2011 6,005 323 (195) (1,988) 4,145 87,884 47.16 4,145 (4,479) 1,334 1,000 yTd Q4 2011 6,794 1,936 (684) (2,141) 5,905 116,410 50.73 5,905 (5,591) 1,690 2,004 Payable silver ounces 350,961 444,695 Cash cost per ounce of payable silver ($/oz) 2.85 4.51 Commercial production commenced on September 1, 2011. 1 By-product credits as included in the provisional sales. 2 2010 and 2011 ﬁgures in accordance with IFRS. 3 Includes depletion, depreciation, distribution, community relations, government royalties and mining taxes, and workers participation. 38 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS LIQUIDITY AND CAPITAL RESOURCES The capital of the Company consists of equity and available credit facility, 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 Company’s cash and cash equivalents as at December 31, 2011 totalled $38.73 million, and short term investments totalled $17.00 million. The $31.87 million decrease (2010: $37.38 million increase) in cash and cash equivalents at December 31, 2011 compared to the end of the prior year is largely due to the use of $45.48 million on the construction of the San Jose mine. In 2010, the $37.38 million increase in cash is primarily a result of the $74.92 million net proceeds on the issuance of shares. As at December 31, 2011, working capital amounted to $63.90 million (2010: $97.07 million). The 2011 decrease in working capital reﬂects: decreases in cash and cash equivalents and short term investments; increases in trade and other payables due to related parties, derivative liabilities, provisions, and current portion of long term liabilities; offset by increases in derivative assets, accounts receivable and other assets, GST/HST and value added tax receivable, inventories. During the fourth quarter ended December 31, 2011, cash generated by operating activities before changes in non-cash working capital items, income taxes paid, and interest income paid and received was $10.45 million (Q4 2010: $7.60 million). During the year ended December 31, 2011, cash generated by operating activities before changes in non-cash working capital items, income taxes paid, and interest income paid and received was $49.76 million (2010: $28.68 million). Changes in non-cash working capital items amounted to $3.60 million (2010: $2.66 million), and income taxes paid and interest income paid and received amounted to $14.25 million (2010: $6.97 million), resulting in net cash provided by operating activities of $35.51 million (2010: $21.71 million). Cash generated by operating activities before changes in working capital, income taxes, and interest income is calculated as follows: oPeRaTing aCTiViTieS Net income $ (1,755) $ 4,333 $ 19,533 $ 16,003 Three months ended december 31 2011 2010 years ended december 31, 2011 2010 Items not involving cash Depletion and depreciation Accretion of provisions Income tax expense Share-based payments (recovery) Unrealized (gain) on commodity contracts Write-off of deferred exploration costs Impairment of mineral properties, property, plant and equipment (Gain) loss on disposal of mineral properties, property, plant and equipment Accrued interest on long term loans receivable and payable 3,943 57 6,199 475 1,089 – 1,894 16 7 1,782 42 3,700 676 (325) 443 – 6 14 9,421 173 18,802 3,682 (116) – 1,894 (59) 24 6,462 163 11,510 (501) (2,922) 443 – 127 50 Changes in non-cash working capital items Accounts receivable and other assets Inventories Trade and other payables Due to/from related parties Provisions Cash provided by operating activities before 11,925 10,671 53,354 31,335 1,693 2,189) (963) 183 (201) (3,091) (144) 165 (2) – (3,085) (7,273) 6,829 134 (201) (4,788) (1,536) 3,677 (9) – interest and income taxes $ 10,448 $ 7,599 $ 49,758 $ 28,679 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 39 MANAGEMENT’S DISCUSSION AND ANALYSIS Cash consumed by the Company for the fourth quarter ended December 31, 2011, in investing activities totalled $31.64 million (Q4 2010: $24.77 million) with $16.24 million (Q4 2010: $14.37 million) for mineral properties, property, plant and equipment, $0.63 million (Q4 2010: receipts $0.14 million) net advances on deposits on long term assets, $15.05 million (Q4 2010: $9.48 million) net purchases of short term investments, offset by receipts of VAT $0.28 million (Q4 2010: payments $1.13 million), and proceeds on disposal of mineral properties, property, plant and equipment $nil (Q4 2010: $0.07 million). Cash consumed by the Company, for the year ended December 31, 2011, in investing activities totalled $69.86 million (2010: $58.06 million) with $76.68 million (2010: $36.71 million) for mineral properties, property, plant and equipment, $3.57 million (2010: advances $4.66 million) for net receipts on deposits on long term assets, $3.73 million net redemptions (2010: purchases $13.85 million) of short term investments, payments of VAT of $0.52 million (2010: $2.92 million), and offset by proceeds on disposal of mineral properties, property, plant, and equipment of $0.04 million (2010: $0.08 million). The total investment in San Jose amounted to $45.48 million. During the fourth quarter ended December 31, 2011, cash provided by ﬁnancing activities totalled $1.95 million (Q4 2010: $42.73 million) with repayment of ﬁnance lease obligations of $0.30 million (Q4 2010: $0.26 million), offset by cash provided by net proceeds on the issuance of common shares of $2.25 million (Q4 2010: $42.99 million). During the year ended December 31, 2011, cash provided by ﬁnancing activities totalled $2.48 million (2010: $73.74 million) with repayment of ﬁnance lease obligations of $1.18 million (2010: $1.18 million), offset by cash provided by net proceeds on the issuance of common shares of $3.66 million (2010: $74.92 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. In the event that utilization under the credit facility is less than $10 million, a commitment fee of 1.50% per annum is payable quarterly on the unutilized portion of the available credit facility. No funds were drawn from this credit facility during the year. The Company has raised funds from two prospectus ﬁnancings in 2010. 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 expected use of proceeds* actual use of proceeds** $ 6.7 16.6 1.9 3.0 – – $ 28.2 $ 11.2 30.4 4.4 3.5 2.5 2.5 $ 54.5 Variance $ (4.5) (13.8) (2.5) (0.5) (2.5) (2.5) $ (26.3) expressed in Cad $ millions expected use of proceeds* actual use of proceeds** $ 14.5 5.5 17.7 $ 37.7 $ – 10.7 26.3 $ 37.0 Variance $ 14.5 (5.2) (8.6) $ 0.7 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** Planned expansion Exploration programs Working capital Total * Excludes over-allotment. ** Funds to be utilized post development. 40 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS Management believes the Company’s cash position, along with its ongoing operations, in Caylloma and San Jose, and the available 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. ConTRaCTuaL obLigaTionS The Company expects the following maturities of its ﬁnancial liabilities (including interest), ﬁnance leases, and other contractual commitments: Trade and other payables Due to related parties Derivative liabilities Income tax payable Long term liabilities Operating leases Provisions expected payments due by period as at december 31, 2011 expressed in $ millions 1–3 years 4–5 years $ – – – – 2.77 1.41 0.85 $ – – – – – 1.18 0.77 after 5 years $ – – – – – 0.53 3.73 $ 5.03 $ 1.95 $ 4.26 Total $ 17.16 0.21 0.09 3.92 4.30 3.82 6.08 $ 35.58 Less than 1 year $ 17.16 0.21 0.09 3.92 1.53 0.70 0.73 $ 24.34 CaPiTaL CoMMiTMenTS (exPReSSed in $’000’S) As at December 31, 2011, $8.12 million of capital commitments not disclosed elsewhere in the consolidated ﬁnancial statements, and forecasted to be expended within one year, includes the following: $5.80 million for the ramp development at the San Jose property located in Mexico; $2.25 million for the tailing dam, concentrator plant and electrical infrastructure renewal, and mine camp development at the Caylloma Property; and $0.08 million for software development. oTHeR CoMMiTMenTS (exPReSSed in $’000’S) 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 3,500 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 and expiring in 2017. 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, jointly with Radius Gold Inc., a related party by way of common directors, has entered into an ofﬁce premise lease located in Canada, effective on November 28, 2011, the date the Company commenced carrying on business in the premises. The shared ofﬁce with Radius has been ﬁnalized with the Company obligated to pay 50% of the total rent payable. The lease term is eight years with the Company’s annual net rent payable, on 3,195 rentable square feet, as follows: • years one to two $111; • years three to ﬁve $115; and, • years six to eight $118. In addition, estimated operating costs, utilities, and realty taxes is $71 in the ﬁrst year of occupancy. During 2011, the Company has advanced 50% of the three month security deposit in the amount of $47. On May 24, 2010, the Company entered into a seven year ofﬁce premise lease located Peru. The annual rent payable on 1,717 rentable square meters for ofﬁce space, is as follows: • year one $289; • year two $297; • year three $306; and, • years four through seven the lease is subject a minimum annual increase of 3% or the Consumer Price Index published by Bureau of Labor Statistics of the United States Department of Labor, whichever is higher. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 41 MANAGEMENT’S DISCUSSION AND ANALYSIS The lease also includes the use of additional space for mini-warehouse and parking spots, the obligation for which is $58 per annum for the ﬁrst year and is subject to an annual increase of 3% as stated above until the end of the lease. As at December 31, 2011, the Company has advanced rent $159 (2010: $426) and provided a security deposit of $44. On March 15, 2011, the Company entered into a one year ofﬁce premise lease located in Mexico with an annual lease obligation of $37. Ofﬁce premises – Canada Ofﬁce premises – Peru Ofﬁce premises – Mexico Total ofﬁce premises Computer equipment – Peru Computer equipment – Mexico Total computer equipment Total operating leases expected payments due by period as at december 31, 2011 Less than 1 year $ 181 363 8 $ 552 128 16 $ 144 $ 696 1–3 years 4–5 years $ 549 758 – $ 1,307 75 28 $ 103 $ 1,410 $ 372 805 – $ 1,177 – – – $ $ 1,177 after 5 years $ 359 172 – $ 531 – – $ – $ 531 Total $ 1,461 2,098 8 $ 3,567 203 44 $ 247 $ 3,814 On February 17, 2012, the Company entered into a one year ofﬁce premise lease, effective March 1, 2012, located in Mexico with an annual lease obligation of $18. oTHeR ConTingenCieS (exPReSSed in $’000’S) In February 2009, the Environmental Assessment and Oversight Agency (“OEFA”) in Peru, alleged the Company had ﬁve violations: two were for breaches of recommendations; two for excess of total suspended solids in water over the maximum allowable; and an alleged unauthorized discharge of efﬂuent. The Ministry of Energy and Mines in Peru (“OSINERGMIN”) decided to close the two alleged violations for failure to adopt recommendations and punish the Company for the three alleged violations and imposed a ﬁne of $200 in 2010. The Company appealed on June 23, 2010. Subsequent to December 31, 2011 and on February 22, 2012, the alleged unauthorized discharge of efﬂuent was dismissed and conﬁrmed a ﬁne of $133 for the two alleged violations of excess of total suspended solids in water over the maximum allowable. The Company is proceeding with an administrative appeal to the Ministry of Energy and Mines in Peru (“OSINERGMIN”) for the remaining two alleged offenses. The Company believes it is more likely than not that it will defend itself successfully in the claims and therefore has not recorded a provision for the potential exposure relating to these alleged violations. 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; and, • the dollar value cannot be reasonably estimated. The Caylloma mine closure plan was approved in November 2009 with total closure costs of $3,587 of which $1,756 is subject to annual collateral in the form of a letter of guarantee, to be awarded each year in increments of $146 over 12 years 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 $439. This bank letter of guarantee expires 360 days from December 2011. 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 were renewed in June 2011 with expiry 360 days to June 2012. 42 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS The Company acts as guarantor to ﬁnance lease obligations held by two of its mining contractors. These ﬁnance lease contracts are related to the acquisition of mining equipment deployed at the Caylloma mine. As at December 31, 2011, these obligations amounted to $231 with $74 maturing in 2012 and $157 maturing in 2013. 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 are material to investors, other than those disclosed in this MD&A and the consolidated ﬁnancial statements and the related notes. DERIVATIVES Lead forward contracts Zinc forward contracts Silver forward contracts Total december 31, 2011 expressed in $ millions december 31, 2010 assets Liabilities assets Liabilities – 0.07 – 0.05 – 0.04 – – – 0.01 0.01 0.11 $ 0.07 $ 0.09 $ – $ 0.13 The Company occasionally 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. As at the end of the period no such contracts are outstanding. Additionally, the Company enters regularly into short term forward and 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 forward sale and option contracts are settled against the arithmetic average of metal spot prices over the month in which the contract matures. No initial premium associated with these trades has been paid. RELATED PARTY TRANSACTIONS Parties are considered to be related if one party has the ability directly, or indirectly, to control the other party or exercise signiﬁcant inﬂuence over the other party in making ﬁnancial and operating decisions. Parties are also considered to be related if they are subject to common control, related parties may be individuals or corporate entities. A transaction is considered to be a related party transaction when there is a transfer of resources or obligations between related parties. The consolidated ﬁnancial statements include the ﬁnancial statements of Fortuna Silver Mines Inc. and its subsidiaries listed in the following table: name Country of incorporation Minera Bateas S.A.C. Fortuna Silver Mines Peru S.A.C. Compania Minera Cuzcatlan SA Fortuna Silver Mexico, S.A. de CV Fortuna Silver (Barbados) Inc. Continuum Resources Ltd. Peru Peru Mexico Mexico Barbados Canada Fortuna Silver Mexico, S.A. de CV was incorporated in 2011. equity interest as at december 31, 2011 100% 100% 100% 100% 100% 100% 2010 100% 100% 100% n/a 100% 100% FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 43 MANAGEMENT’S DISCUSSION AND ANALYSIS a) PuRCHaSe oF goodS and SeRViCeS The Company entered into the following related party transactions: Transactions with related parties Salaries and wages 1,2 Other general and administrative expenses 2 Leasehold improvements 2 expressed in $‘000’s years ended december 31, 2011 173 292 93 558 $ $ 2010 174 185 – 359 $ $ 1 Salaries and wages includes employees' salaries and beneﬁts charged to the Company based on a percentage of the estimated hours worked for the Company. 2 Radius Gold Inc. (“Radius”) has directors in common with the Company and shares ofﬁce space, and is reimbursed for salaries and wages, general and administrative costs, and leasehold improvements incurred on behalf of the Company. During the year ended December 31, 2011, the Company transferred two mining concessions to Focus Ventures Ltd., a Company with directors in common, in exchange for a 1% net smelter return royalty. During the year ended December 31, 2011, the Company issued 6,756 (2010: 7,813) common shares, at a fair market value of $4.44 (2010: $2.56) per share and paid $0.03 million cash (2010: $0.02 million) to Radius, under the option to acquire a 60% interest in Tlacolula silver project located in the State of Oaxaca, Mexico. Subsequent to the year ended December 31, 2011 to March 23, 2012, the Company issued 8,605 common shares, at a fair market value of $5.81 per share and paid $0.05 million cash to Radius, under the option to acquire a 60% interest in Tlacolula silver project located in the State of Oaxaca, Mexico. b) Key ManageMenT CoMPenSaTion Key management includes all persons named or performing the duties of Vice-President, Chief Financial Ofﬁcer, President, Chief Executive Ofﬁcer, and non-executive Directors of the Company. The compensation paid or payable to key management for services is shown below: Salaries and other short term employee beneﬁts Directors fees Consulting fees Share-based payments expressed in $‘000’s years ended december 31, $ 2011 3,492 333 416 4,398 $ 2010 2,633 300 174 188 $ 8,639 $ 3,295 The share-based payments includes the change in the deferred share unit (“DSU”) and restricted share unit (“RSU”) fair value over each reporting period and payments made under the DSU and RSU plans and the non-cancellation of share options. Consulting fees includes fees paid to two non-executive directors in both 2011 and 2010. C) yeaR end baLanCeS aRiSing FRoM PuRCHaSeS oF goodS/SeRViCeS Amounts due to/(from) related parties amounts due to/(from) related parties Owing from a director and ofﬁcer 3 Owing to a company with common directors 2 expressed in $‘000’s december 31, 2011 december 31, 2010 $ $ (36) 205 169 $ $ (1) 41 40 3 Owing from a director includes non-interest bearing advances to a director and ofﬁcers at December 31, 2011 and one ofﬁcer and director at December 31, 2010. 44 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS SIGNIFICANT ACCOUNTING JUDGMENTS AND ESTIMATES The preparation of these consolidated ﬁnancial statements requires management to make judgments and estimates that affect the reported amounts of assets and liabilities at the date of the ﬁnancial statements and reported amounts of expenses during the reporting period. Actual outcomes could differ from these judgments and estimates. The consolidated ﬁnancial statements include judgments and estimates which, by their nature, are uncertain. The impacts of such judgments and estimates are pervasive throughout the consolidated ﬁnancial statements, and may require accounting adjustments based on future occurrences. Revisions to accounting estimates are recognized in the period in which the estimate is revised and the revision affects both current and future periods. Signiﬁcant assumptions about the future and other sources of judgments and estimates that management has made at the statement of ﬁnancial position date, that could result in a material adjustment to the carrying amounts of assets and liabilities, in the event that actual results differ from assumptions made, relate to, but are not limited to, the following: i. Critical judgments • The analysis of the functional currency for each entity of the Company. In concluding that the United States dollar (“US$”) functional currency for its Peruvian and Mexican entities and the Canadian and Barbados entities have a Canadian dollar (“CAD$”) functional currency, management considered the currency that mainly inﬂuences the cost of providing goods and services in each jurisdiction in which the Company operates. As no single currency was clearly dominant the Company also considered secondary indicators including the currency in which funds from ﬁnancing activities are denominated and the currency in which funds are retained. • In concluding when commercial production has been achieved, the Company considered the following factors: • all major capital expenditures to bring the mine to the condition necessary for it to be capable of operating in the manner intended by management have been completed; • the mine or mill is operating within eighty percent of design capacity; • metallurgical recoveries are achieved within eighty percent of projections; and, • the ability to sustain ongoing production of ore at a steady or increasing level. • The identiﬁcation of reportable segments, basis for measurement and disclosure of the segmented information. • The determination of estimated useful lives and residual values of tangible and long-lived assets and the measurement of depreciation expense. • The identiﬁcation of impairment indicators, cash generating units and determination of value in use and the write down of tangible and long lived assets. • Measurement of ﬁnancial instruments involve signiﬁcant judgments related to interpretation of the terms of the instrument, identiﬁcation, classiﬁcation, impairment and the overall measurement to approximate fair values. ii. estimates • the recoverability of amounts receivable which are included in the consolidated statements of ﬁnancial position; • the estimation of assay grades of metal concentrates sold in the determination of the carrying value of accounts receivable which are included in the consolidated statements of ﬁnancial position and included as sales in the consolidated statements of income; • the carrying value of the short term investments and the recoverability of the carrying value which are included in the consolidated statements of ﬁnancial position; • the determination of net realizable value of inventories on the consolidated statements of ﬁnancial position; • the estimated useful lives of property, plant and equipment which are included in the consolidated statements of ﬁnancial position and the related depreciation included in the consolidated statements of income; • the determination of mineral reserves, carrying amount of mineral properties, and depletion of mineral properties included in the consolidated statements of ﬁnancial position and the related depletion included in the consolidated statements of income; • review of tangible and intangible assets carrying value, the determination of whether these assets are impaired and the measurement of impairment charges or reversals which are included in the consolidated statements of income; • the determination of the fair value of ﬁnancial instruments and derivatives included in the consolidated statements of ﬁnancial position; FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 45 MANAGEMENT’S DISCUSSION AND ANALYSIS • the fair value estimation of share-based awards included in the consolidated statements of ﬁnancial position and the inputs used in accounting for share-based compensation expense in the consolidated statements of income; • the provision for income taxes which is included in the consolidated statements of income and composition of deferred income tax asset and liabilities included in the consolidated statement of ﬁnancial position; • the recognition of deferred income tax assets, amounts recorded for uncertain tax positions, the measurement of income tax expense and indirect taxes included in the consolidated statement of ﬁnancial position; • the inputs used in determining the net present value of the liability for provisions related to decommissioning and restoration included in the consolidated statements of ﬁnancial position; • the inputs used in determining the various commitments and contingencies accrued in the consolidated statements of ﬁnancial position; and, • the assessment of indications of impairment of each mineral properties and related determination of the net realizable value and write-down of those properties where applicable. FINANCIAL INSTRUMENTS AND RELATED RISKS (EXPRESSED IN 000’S) 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, derivative assets, trade receivable from concentrate sales, other accounts receivables, trade and other payables, due to related parties, and derivative liabilities 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. The amortized value of long term receivables approximates their fair value as these are measured at the amortized cost using the effective interest method. The fair value of the lease and long term liabilities is $5,531 as at December 31, 2011. 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 trade receivable concentrate sales, 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 Trade receivable from concentrate sales Derivatives Level 1 Level 2 Level 3 Total expressed in $’000’s $ $ 38,730 17,000 – – – – 11,287 (17) $ 55,730 $ 11,270 $ $ – – – – – $ 38,730 17,000 11,287 (17) $ 67,000 There were no changes in the levels during the year ended December 31, 2011. 46 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS Cash and cash equivalents Short term investments Trade receivable from concentrate sales Derivatives Level 1 Level 2 Level 3 Total expressed in $’000’s $ $ 70,298 20,509 – – – – 12,551 (133) $ 90,807 $ 12,418 $ $ – – – – – $ 70,298 20,509 12,551 (133) $ 103,225 There were no changes in the levels during the year ended December 31, 2010. Accounts receivable includes trade receivable from concentrate sales, provisional price adjustments, and ﬁnal price adjustments. 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. As such, these accounts receivable are classiﬁed within level 2 of the fair value hierarchy. 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, 2011, there have been no changes in the classiﬁcation of ﬁnancial assets and liabilities in levels 1, 2, and 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 and Mexico 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 income, ﬁnancial position, or cash ﬂows. The Company has not hedged its exposure to currency ﬂuctuations. As at December 31, 2011, 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 Accounts receivable and other assets Deposits on long term assets Trade and other payables Provisions, current Income tax payable Leases and long term liabilities Provisions december 31, 2011 Canadian dollars nuevo Soles Mexican Pesos Canadian dollars expressed in $’000’s december 31, 2010 nuevo Soles Mexican Pesos $ 18,457 42 – (1,580) – – (2,691) – S/. 1,396 5,657 – (17,993) (1,351) (10,581) – (8,079) $ 1,758 58,939 – (24,310) (3,163) – – (17,494) $ 54,782 71 – (625) – – (1,999) – S/. 741 1,304 – (15,493) – (11,775) – (9,169) $ 2,201 42,452 24,209 (6,390) – – – (19,959) Total 14,228 (30,951) 15,730 52,229 (34,392) 42,513 Total US$ equivalent 13,950 (11,476) 1,125 52,219 (12,244) 3,440 Based on the above net exposure as at December 31, 2011, 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, as follows: impact to other comprehensive income of $1,550 (2010: $5,802) and a net loss of $1,150 (2010: $978). 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. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 47 MANAGEMENT’S DISCUSSION AND ANALYSIS 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. The Company’s maximum exposure to credit risk at December 31, 2011 is as follows: Cash and cash equivalents Short term investments Accounts receivable Derivative assets Due from related parties GST/HST and value added tax receivable expressed in '000's december 31, 2011 december 31, 2010 $ 38,730 17,000 14,391 70 36 4,777 $ 70,298 20,509 12,551 – – 3,542 $ 75,004 $ 106,900 The carrying amount of ﬁnancial assets recorded in the ﬁnancial statements represents the Company’s maximum exposure to credit risk. The Company believes it is not exposed to signiﬁcant credit risk and overall, the Company’s credit risk has not declined signiﬁcantly from the prior year. 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. Refer to Contractual Obligations for the expected payments due as at December 31, 2011. CHANGES IN ACCOUNTING POLICIES INCLUDING INITIAL ADOPTION The Company is currently assessing the impact of adopting the new accounting standards, noted below, on our consolidated ﬁnancial statements. The following standards and amendments to existing standards have been published and are mandatory for the Company’s annual accounting periods beginning January 1, 2012, or later: i) new accounting Standards impacting on or after january 1, 2012 iFRS 7 Financial Instruments: Disclosures (Amendment) The amendment, effective for annual periods beginning on or after July 1, 2011, with early application permitted, requires additional quantitative and qualitative disclosures relating to transfers of ﬁnancial assets, where: ﬁnancial assets are derecognized in their entirety, but where the entity has a continuing involvement in them; ﬁnancial assets that are not derecognized in their entirety. iaS 12 Income Taxes (Amendment) IAS 12 Income Taxes, amendments regarding Deferred Tax: Recovery of Underlying Assets introduces an exception to the existing principle for the measurement of deferred tax assets and liabilities arising on investment property measured at fair value, and the requirement that deferred tax on non-depreciable assets measured using the revaluation model in IAS 16 should always be measured on a sale basis. The amendment is effective for annual periods beginning on or after January 1, 2012. ii) new accounting Standards impacting on or after july 1, 2012 iaS 1 Presentation of Financial Statements (Amendment) The amendments to IAS 1 Presentation of Financial Statements require companies preparing ﬁnancial statements in accordance with IFRSs to group together items within OCI that may be reclassiﬁed to the proﬁt or loss section of the income statement. The amendments retain the 'one or two statement' approach at the option of the entity and only revise the way other comprehensive income is presented: requiring separate subtotals for those elements which may be 'recycled' (e.g. cash-ﬂow hedging, foreign currency translation), and those elements that will not (e.g. fair value through 48 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS OCI items under IFRS 9). In addition, the tax associated with items presented before tax to be shown separately for each of the two groups of OCI items (without changing the option to present items of OCI either before tax or net of tax). The amendment is effective for annual periods beginning on or after July 1, 2012. iii) new accounting Standards impacting on or after january 1, 2013 iFRS 7 Financial Instruments: Disclosures in Respect of Offsetting (Amendment) At its meeting on December 13-15, 2011, the IASB approved amendments to IFRS 7, Financial Instruments: Disclosures, with respect to offsetting ﬁnancial assets and ﬁnancial liabilities. The common disclosure requirements issued by the IASB and the FASB in December 2011 are intended to help investors and other users to better assess the effect or potential effect of offsetting arrangements on a company's ﬁnancial position. Companies and other entities are required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The required disclosures should be provided retrospectively. iFRS 10 Consolidated Financial Statements IFRS 10 Consolidated Financial Statements replaces the portion of IAS 27 Consolidated and Separate Financial Statements that addresses the accounting for consolidated ﬁnancial statements, and SIC12 Consolidation - Special Purpose Entities. IFRS 10 establishes principles for the presentation and preparation of consolidated ﬁnancial statements when an entity controls one or more entities. This standard (i) requires a parent entity (an entity that controls one or more other entities) to present consolidated ﬁnancial statements; (ii) deﬁnes the principle of control, and establishes control as a basis for consolidation; (iii) sets out how to apply the principle of control whether an investor controls an investee and therefore must consolidate the investee; and (iv) sets out the accounting requirements for the preparation of consolidated ﬁnancial statements. IFRS 10 is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. IFRS 10 may be adopted to an earlier accounting period, but in doing so, an entity must disclose the fact that it has early adopted the standard and apply IFRS 11 Joint Arrangements, IFRS 12 Disclosure of Interests in Other Entities, IAS 27 Separate Financial Statements (as amended in 2011), IAS 28 Investments in Associates and Joint Ventures (as amended in 2011). iFRS 11 Joint Arrangements IFRS 11 replaces IAS 31 Interest in Joint Ventures and SIC-13 Jointly-Controlled Entities-Non-Monetary Contributions by Venturers. This standard establishes the core principle that a party to a joint arrangement determines the type of joint arrangement in which it is involved by assessing its rights and obligations and accounts for those rights and obligations in accordance with that type of joint arrangement (joint operations or joint ventures). This standard is effective for annual periods on or after January 1, 2013, with early adoption permitted. iFRS 12 Disclosure of Interests in Other Entities IFRS 12 combines the disclosure requirements for an entity’s interest in subsidiaries, joint arrangements, associates and structured entities into one comprehensive disclosure standard. This standard requires the disclosure of information that enable users of ﬁnancial statements to evaluate the nature of, and risks associated with, its interest in other entities and the effects of those interests on its ﬁnancial position, ﬁnancial performance and cash ﬂows. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted, and entities are permitted to incorporate any of the new disclosures into their ﬁnancial statements before that date. iFRS 13 Fair Value Measurement IFRS 13 Fair Value Measurement provides guidance on how to measure fair value, but does not change when fair value is required or permitted under IFRS. IFRS 13 deﬁnes fair value, sets out a single IFRS framework for measuring fair value and requires disclosures about fair value measurements. IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures about fair value measurements (and measurements, such as fair value less costs to sell, based on fair value or disclosures about those measurements), except for: share-based payment transactions within the scope of IFRS 2 Share-based Payment; leasing transactions with the scope of IAS 17 Leases; measurements that have some similarities to fair value that are not fair value, such as net realizable value in IAS 2 Inventories; or value in use IAS 36 Impairment of Assets. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 49 MANAGEMENT’S DISCUSSION AND ANALYSIS iaS 19 Post-employment Beneﬁts On June 16, 2011 the IASB issued amendments to IAS 19, Employee Beneﬁt, in order to improve the accounting for pensions and other post-employment beneﬁts. The amendments make important improvements by: • eliminating the option to defer the recognition of gains and losses, known as the ‘corridor method’ or the “deferral and amortization approach”; • streamlining the presentation of changes in assets and liabilities arising from deﬁned beneﬁt plans, including requiring re-measurements to be presented in OCI, thereby separating those changes from changes that many perceive to be the result of an entity’s day-to-day operations; • enhancing the disclosure requirements for deﬁned beneﬁt plans, providing better information about the characteristics of deﬁned beneﬁt plans and the risks that entities are exposed to through participation in those plans. The amendments are effective for ﬁnancial years beginning on or after January 1, 2013. Earlier application is permitted. iaS 27 Separate Financial Statements IAS 27 has the objective of setting standards to be applied in accounting for investments in subsidiaries, jointly controlled entities, and associates when an entity elects, or is required by local regulations, to present separate (non-consolidated) ﬁnancial statements. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. This standard will not have an impact on the consolidated ﬁnancial statements. iaS 28 Investments in Associates and Joint Ventures IAS 28 prescribes the accounting for investments in associates and to set the requirements for the application of the equity method when accounting for investments in associates and joint ventures. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. iv) new accounting Standards impacting on or after january 1, 2014 iaS 32 Financial Instruments - Presentation in Respect of Offsetting (Amendment) At its meeting on December 13-15, 2011, the IASB approved amendments to IFRS 7, Financial Instruments: Disclosures, with respect to offsetting ﬁnancial assets and ﬁnancial liabilities. As part of this project the IASB also clariﬁed aspects of IAS 32, Financial Instruments: Presentation. The amendments to IAS 32 address inconsistencies in current practice when applying the requirements. The amendments are effective for annual periods beginning on or after January 1, 2014 and are required to be applied retrospectively. v) new accounting Standards impacting on or after january 1, 2015 iFRS 9 Financial Instruments - Classiﬁcation and Measurement IFRS 9, Financial Instruments: IFRS 9 introduces the new requirements for the classiﬁcation, measurement and de- recognition of ﬁnancial assets and ﬁnancial liabilities. Speciﬁcally, IFRS 9 requires all recognized ﬁnancial assets that are within the scope of IAS 39 Financial Instruments: Recognition and Measurement to be subsequently measured at amortized cost or fair value, and all ﬁnancial liabilities classiﬁed as subsequently measured at amortized cost except for ﬁnancial liabilities as at FVTPL. The amendments are effective for annual periods beginning on or after January 1, 2015, with earlier application permitted. 50 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS 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. As at March 23, 2012, there are 481,465 DSU outstanding with a fair value of $2.98 million and 265,231 RSU outstanding with a fair value of $1.45 million. SHaRe PoSiTion and ouTSTanding WaRRanTS and oPTionS The Company’s outstanding share position as at March 23, 2012 is 125,268,751 common shares. In addition, a total of 3,696,560 incentive stock options are currently outstanding as follows: Type of Security Incentive Stock Options: Total outstanding options exercise Price (Cad$) $4.46 $4.46 $1.35 $2.29 $1.75 $0.85 $1.55 $1.66 $0.85 $2.22 $6.67 $0.85 $0.85 $0.85 $0.85 $0.83 no. of Shares 8,271 1,663,651 200,000 50,000 10,000 2,500 225,000 225,000 35,000 350,000 184,138 38,000 25,000 250,000 230,000 200,000 3,696,560 expiry date March 30, 2012 June 8, 2014 February 5, 2016 March 30, 2016 May 8, 2016 July 5, 2016 July 5, 2016 July 10, 2016 January 11, 2017 January 11, 2017 February 20, 2017 June 27, 2017 October 24, 2017 October 5, 2018 November 5, 2018 July 6, 2019 INTERNATIONAL FINANCIAL REPORTING STANDARDS (“IFRS”) Effective January 1, 2011, Canadian publicly listed entities were required to prepare their ﬁnancial statements in accordance with IFRS. Due to the requirement to present comparative ﬁnancial information, the effective transition date is January 1, 2010. Refer to Note 23 of the consolidated ﬁnancial statements for the year ended December 31, 2011. Our IFRS conversion team identiﬁed three phases to our conversion: Scoping and Diagnostics, Analysis and Development, and Implementation and Review. We have now completed our IFRS conversion project through implementation. Review and post-implementation will continue in future periods, as outlined below. The following outlines our transition project, IFRS transitional impacts and the on-going impact of IFRS on our ﬁnancial results. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 51 MANAGEMENT’S DISCUSSION AND ANALYSIS TRanSiTionaL FinanCiaL iMPaCT equity impact As a result of the policy choices we have selected and the changes we were required to make under IFRS, we have recorded a reduction in our equity of approximately $1.20 million and $3.42 million as at January 1, 2010 and December 31, 2010, respectively. The table below outlines adjustments to our equity on adoption of IFRS on January 1, 2010 and December 31, 2010. expressed in $ millions Equity, CAD GAAP Adjustments: Effect of foreign exchange on inventory, deposits on long term assets, and mineral properties, property, plant and equipment Deferred income tax adjustments Transfer of accumulated other comprehensive income to retained earnings Reset accumulated other comprehensive income to zero Adjustment to revise provisions Adjustment for depletion on mineral properties related to provisons Total iFRS adjustments to equity equity, iFRS Note: There may be differences due to rounding of decimal places. january 1, 2010 december 31, 2010 $ 112.56 $ 206.01 (2.54) 1.48 2.90 (2.90) (0.32) 0.18 (1.20) (5.34) 1.94 2.90 (2.90) (0.25) 0.23 (3.42) $ 111.36 $ 202.59 A reconciliation of our comprehensive income under CAD GAAP and IFRS for the year ended December 31, 2010 and a discussion of the impact of IFRS on our cash ﬂows are provided below. Comprehensive income impact As a result of the policy choices we have selected and the changes we were required to make under IFRS, we have also recorded an increase in our net income of approximately $3.0 million for the year ended December 31, 2010. We have recorded a decrease in our total comprehensive income of approximately $2.2 million for the year ended December 31, 2010. The following is a summary of the adjustments to comprehensive income for year ended December 31, 2010 under IFRS (all of which are outlined in the notes to our consolidated ﬁnancial statements): year ended december 31, 2010 expressed in $ millions Cad gaaP effect of Transition to iFRS Income (loss) for the year Other comprehensive income (loss) Transfer of unrealized loss to realized loss upon reduction of net investment, net of taxes Unrealized (loss) gain on translation to presentation currency on foreign operations Other comprehensive income $ 13.0 $ 3.0 2.1 5.9 8.0 (2.1) (3.2) (5.3) iFRS $ 16.0 – 2.7 2.7 Total comprehensive income for the year $ 20.9 $ (2.2) $ 18.7 Note: There may be differences due to rounding of decimal places. Cash Flow impact The adoption of IFRS has had no material impact on the net cash ﬂows of the Company. The changes made to the Consolidated Statements of Financial Position and Consolidated Statements of Comprehensive Income have resulted in reclassiﬁcations of various amounts on the Consolidated Statements of Cash Flows, however there is no net impact on cash and cash equivalents. 52 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS Financial Statement Presentation Changes The transition to IFRS has resulted in ﬁnancial statement presentation changes in our ﬁnancial statements, most signiﬁcantly on the consolidated statement of income. The changes to the balance sheet relate mainly to the combining of mineral properties, property, plant and equipment and renaming of asset retirement obligations to provisions; future income tax liability to deferred income tax liabilities; and contributed surplus to share option and warrant reserve. The following is a summary of the signiﬁcant changes to our consolidated statement of income: • expenses by function and nature – our statement of income presents expenses by function. Accordingly, depreciation, depletion, and accretion are no longer presented as a separate line item on the statement of income but depreciation and depletion are included in cost of sales. Accretion of provisions is included in interest expense; • government royalties to cost of sales from selling, general and administrative expenses; • distribution costs to cost of sales from selling, general and administrative expenses; • community relation costs to cost of sales from selling, general and administrative expenses; • other income and expenses from interest and other income and expenses to selling, general and administrative expenses; • interest expense includes interest on debt ﬁnancing and accretion of provisions; and, • current workers participation from income tax to cost of sales and selling, general and administrative expenses. In addition, exploration and evaluation costs moved from selling, general and administrative expenses. The above changes are reclassiﬁcations within our statement of income so there is no net impact to our income as a result of these changes. Control activities For all changes to policies and procedures that have been identiﬁed, the effectiveness of internal controls over ﬁnancial reporting and disclosure controls and procedures has been assessed and any changes have been implemented. In addition, controls over the IFRS changeover process have been implemented, as necessary. We have identiﬁed and implemented the required accounting process changes that resulted from the application of IFRS accounting policies and these changes were not material. We have completed the design, implementation and documentation of the internal controls over accounting process changes resulting from the application of IFRS accounting policies and these changes were not material. We applied our existing control framework to the IFRS changeover process. All accounting policy changes and transitional ﬁnancial position impacts were subject to review by senior management and the Audit Committee of the Board of Directors. business activities and Key Performance Measures We have assessed the impact of the IFRS transition project on our ﬁnancial covenants and key ratios. The transition did not signiﬁcantly impact our covenants and key ratios that have an equity component. We have also reviewed the impact of the IFRS transition project on our compensation arrangements. We have identiﬁed compensation arrangements that are calculated based on indicators in our ﬁnancial statements. We are continuing to work with our Human Resources department to ensure that all compensation arrangements incorporate indicators from our ﬁnancial statements prepared under IFRS in accordance with our compensation policies. information Technology and Systems The IFRS transition project did not have a signiﬁcant impact on our information systems for the convergence periods. We also do not expect signiﬁcant changes in the post-convergence periods. Review The post-implementation phase will involve continuous monitoring of changes in IFRS in future periods. We note that the standard-setting bodies that determine IFRS have signiﬁcant ongoing projects that could impact the IFRS accounting policies that we have selected. In particular, there may be additional new or revised IFRSs or IFRICs in relation to ﬁnancial instruments, hedge accounting, discontinued operations, leases and revenue recognition. We also note that the International Accounting Standards Board is currently working on an extractive industries project, which could signiﬁcantly impact our ﬁnancial statements primarily in the areas of capitalization of exploration costs and disclosures. We have processes in place to ensure that potential changes are monitored and evaluated. The impact of any new IFRSs and IFRIC Interpretations will be evaluated as they are drafted and published. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 53 MANAGEMENT’S DISCUSSION AND ANALYSIS OTHER RISKS AND UNCERTAINTIES There have been no major changes from the reported risks factors outlined in the Annual Information Form for the ﬁnancial year ended December 31, 2011. CONTROLS AND PROCEDURES diSCLoSuRe ConTRoLS and PRoCeduReS The Company’s management, with the participation of the Chief Executive Ofﬁcer and the Chief Financial Ofﬁcer, have evaluated the effectiveness of the Company’s disclosure controls and procedures (as deﬁned in the rules of the SEC and the Canadian Securities Administrators (“CSA”) as of December 31, 2011, and have concluded that such disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it ﬁles or submits under the Securities Exchange Act of 1934 and Canadian securities laws is (i) recorded, processed, summarized and reported within the time periods speciﬁed in SEC rules and forms and Canadian securities laws and (ii) accumulated and communicated to them Company’s management, including its principal executive ofﬁcer and principal ﬁnancial ofﬁcer, to allow timely decisions regarding required disclosure. 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 IFRS as issued by the IASB. 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 year that has materially affected, or is reasonably likely to materially affect, its internal control over ﬁnancial reporting. Management concludes that, as of December 31, 2011, the Company’s internal control over ﬁnancial reporting was effective and no material weaknesses were identiﬁed. OUTLOOK San joSe Mine, MexiCo Exploration at San Jose in 2012 will continue to focus on the evaluation and advancement of multiple mineral occurrences outlined through mapping and stream and soil sampling on the 58,000 hectare land package the Company controls in the area surrounding the San Jose Mine. A 15,000 meter drill program has been budgeted for the year to drill test new targets and follow-up on the results of the 2011 program. CayLLoMa Mine, PeRu For 2012, the mine is scheduled to produce 2 million ounces of silver with additional by-product gold, lead and zinc. Capital projects budgeted for the year total $25 million and include a new tailings facility with total holding capacity for seventeen years, camp improvements, upgrading of the power grid and plant equipment and infrastructure optimizations. 54 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS 2012 PRoduCTion guidanCe For 2012, the Company is scheduled to produce 3.7 million ounces of silver and 17,400 ounces of gold production or 4.6 million Ag Eq ounces plus base metal credits. Mine Caylloma, Peru San Jose, Mexico Total Silver (M oz) gold (k oz) Zinc (M lbs) Lead (M lbs) 2.0 1.7 3.7 2.4 15.0 17.4 21.0 -- 21.0 18.0 -- 18.0 • 2012 forecast silver production of 3.7 million ounces and gold production of 17,400 ounces or 4.6 million Ag Eq ounces plus base metal credits (Ag = US$30/oz, Au = US$1,660/oz; metallurgical recoveries of 88% and 90% for Ag and Au respectively) • Ag Eq = Silver Equivalent Mining Tax in PeRu Effective October 1, 2011, the Peruvian Government approved a change in the tax law for the mining sector which consists of a progressive royalty scheme based on operating margins. Management expects that the impact on taxes paid by its Peruvian subsidiary under the current metal price environment will be between 2 and 3 added percentage points on the total royalty and mining tax. CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS Certain statements contained in this MD&A and any documents incorporated by reference into this MD&A constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995 and Section 21E of the United States Securities Exchange Act of 1934, as amended, and forward-looking information within the meaning of applicable Canadian securities legislation (collectively, “forward-looking statements”). Forward-looking statements express or involve discussions with respect to predictions, expectations, beliefs, plans, projections, objectives, assumptions or future events or performance (often, but not always, identiﬁed 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) and are not statements of historical fact. Forward-looking statements relate to, among other things: • mineral “reserves” and “resources” as they involve the implied assessment, based on estimates and assumptions that the reserves and resources described exist in the quantities predicted or estimated and can be proﬁtably produced in the future; • 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 required third party contractual, regulatory and governmental approvals will be obtained for the development, construction and production of its properties, (2) there being no signiﬁcant disruptions affecting operations, whether due to labor 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) labor 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. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 55 MANAGEMENT’S DISCUSSION AND ANALYSIS 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, 2011 ﬁled with the Canadian Securities Administrators and the U.S. Securities and Exchange Commission and available at www.sedar.com and www.edgar.gov. 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 are cautioned not to 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. 56 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT REGISTERED CHARTERED ACCOUNTANTS To THe boaRd oF diReCToRS and SHaReHoLdeRS oF FoRTuna SiLVeR MineS inC. We have audited the accompanying consolidated ﬁnancial statements of Fortuna Silver Mines Inc. and subsidiaries, which comprise the consolidated statements of ﬁnancial position as at December 31, 2011, December 31, 2010 and January 1, 2010, and the consolidated statements of income, statements of comprehensive income, statements of changes in equity, and statements of cash ﬂows for the years ended December 31, 2011 and December 31, 2010, 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 International Financial Reporting Standards as issued by the International Accounting Standards Board, 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 and the standards of the Public Company Accounting Oversight Board (United States). 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 purpose 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. and subsidiaries as at December 31, 2011, December 31, 2010 and January 1, 2010 and their ﬁnancial performance and cash ﬂows for the years ended December 31, 2011 and December 31, 2010 in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board. (Signed) Deloitte & Touche LLP Independent Registered Chartered Accountants March 23, 2012 Vancouver, Canada FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 57 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF INCOME FoR THe yeaRS ended deCeMbeR 31, (expressed in thousands of uS dollars, except for share and per share amounts) Sales Cost of sales Mine operating income other expenses notes 18 21 2011 2010 23 h) $ 110,004 49,030 $ 74,056 34,844 60,974 39,212 Selling, general and administrative expenses Exploration and evaluation costs Net gain on commodity contracts (Gain) loss on disposal of mineral properties, 10 a) b), 21 21 property, plant and equipment Loss on disposal of investment Write-off of deferred exploration costs Impairment of mineral properties, property, plant and equipment operating income Finance items Interest income Interest expense net ﬁnance income (expense) income before tax Income taxes income for the year Earnings per Share – Basic Earnings per Share – Diluted Weighted average number of shares outstanding – basic Weighted average number of shares outstanding – diluted Expenses by Nature 8 20 13 14 e) i 14 e) ii 14 e) i 14 e) ii 21 The accompanying notes are an integral part of these consolidated ﬁnancial statements. 19,840 1,715 (481) (59) – – 1,894 10,984 547 (736) 127 119 443 – 38,065 27,728 830 (560) 270 38,335 18,802 493 (708) (215) 27,513 11,510 $ 19,533 $ 16,003 $ $ 0.16 0.16 $ $ 0.15 0.14 123,295,063 108,120,452 124,711,984 110,564,767 58 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FoR THe yeaRS ended deCeMbeR 31, (expressed in thousands of uS dollars) income for the year other comprehensive income Unrealized gain on translation of net investment Unrealized (loss) gain on translation to presentation currency on foreign operations other comprehensive income Total comprehensive income for the year notes 2011 2010 23 i) $ 19,533 $ 16,003 751 (79) 672 – 2,723 2,723 $ 20,205 $ 18,726 The accompanying notes are an integral part of these consolidated ﬁnancial statements. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 59 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF CASH FLOWS FoR THe yeaRS ended deCeMbeR 31, (expressed in thousands of uS dollars) oPeRaTing aCTiViTieS Net income Items not involving cash Depletion and depreciation Accretion of provisions Income tax expense Share-based payments (recovery) Unrealized (gain) on commodity contracts Write-off of deferred exploration costs Impairment of mineral properties, property, plant and equipment (Gain) loss on disposal of mineral properties, property, plant and equipment Accrued interest on long term loans receivable and payable Changes in non-cash working capital items Accounts receivable and other assets Inventories Trade and other payables Due to/from related parties Provisions Cash provided by operating activities before interest and income taxes Income taxes paid Interest income paid Interest income received net cash provided by operating activities inVeSTing aCTiViTieS Purchase of short term investments Redemptions in short term investments Expenditures on mineral properties, property, plant and equipment Payments of value added taxes on purchase of property, plant and equipment Advances of deposits on long term assets Receipts of deposits on long term assets Proceeds on disposal of mineral properties, property, plant and equipment net cash used in investing activities FinanCing aCTiViTieS Proceeds from long term debt Repayment of long term debt Net proceeds on issuance of common shares Repayment of ﬁnance lease obligations net cash provided by ﬁnancing activities Effect of exchange rate changes on cash and cash equivalents (deCReaSe) inCReaSe in CaSH and CaSH eQuiVaLenTS Cash and cash equivalents – beginning of year CaSH and CaSH eQuiVaLenTS – end oF yeaR Supplemental cash ﬂow information 3 3 15 The accompanying notes are an integral part of these consolidated ﬁnancial statements. 60 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT notes years ended december 31, 2011 2010 23 i) $ 19,533 $ 16,003 9,421 173 18,802 3,682 (116) – 1,894 (59) 24 6,462 163 11,510 (501) (2,922) 443 – 127 50 53,354 31,335 (3,085) (7,273) 6,829 134 (201) 49,758 (15,007) (80) 837 35,508 (49,671) 53,406 (76,676) (522) (31,859) 35,424 41 (69,857) 18 (18) 3,656 (1,178) 2,478 303 (31,871) 70,298 (4,788) (1,536) 3,677 (9) – 28,679 (7,301) (127) 462 21,713 (47,675) 33,817 (36,711) (2,915) (4,661) – 81 (58,064) – – 74,922 (1,187) 73,735 2,151 37,384 30,763 $ 38,730 $ 70,298 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (expressed in thousands of uS dollars) aSSeTS CuRRenT aSSeTS Cash and cash equivalents Short term investments Derivative assets Accounts receivable and other assets GST/HST and value added tax receivable Inventories notes december 31, 2011 december 31, 2010 23 g) january 1 2010 23 g) 3 4 5 6 6 7 $ 38,730 17,000 70 15,609 4,777 11,291 $ 70,298 20,509 – 13,454 3,542 4,018 $ 30,763 6,034 37 8,635 601 2,328 87,477 111,821 48,398 non-CuRRenT aSSeTS Deposits on long term assets Deferred income tax assets Mineral properties, property, plant and equipment 6 13 b) 8 Total assets LiabiLiTieS and eQuiTy CuRRenT LiabiLiTieS Trade and other payables Due to related parties Derivative liabilities Provisions Income tax payable Current portion of long term liability non-CuRRenT LiabiLiTieS Leases and long term liabilities Provisions Deferred income tax liabilities eQuiTy Share capital Share option and warrant reserve Retained earnings (deﬁcit) Accumulated other comprehensive income 9 10 c) 5 12 13 a) 11 11 12 13 b) 2,260 36 181,833 4,686 – 117,363 16 – 85,175 $ 271,606 $ 233,870 $ 133,589 $ 17,156 169 87 727 3,923 1,512 $ 9,303 40 133 – 4,192 1,083 $ 5,136 49 3,092 – 2,949 1,038 23,574 14,751 12,264 2,764 4,247 12,710 43,295 186,540 10,495 27,881 3,395 31,276 228,311 3,166 4,881 8,482 31,280 180,403 11,116 8,348 2,723 11,071 202,590 1,454 2,917 5,593 22,228 104,701 14,315 (7,655) – (7,655) 111,361 $ 271,606 $ 233,870 $ 133,589 Contingencies and capital commitments Subsequent events 19 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 consolidated ﬁnancial statements. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 61 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY FoR THe yeaRS ended deCeMbeR 31, (expressed in thousands of uS dollars, except for share amounts) Share Capital attributable to equity Holders of the Company notes Shares amount Share option and Warrant Reserve Retained earnings (deﬁcit) accumulated other Compre- hensive income (aoCi”) Total Retained earnings (deﬁcit) and aoCi Total equity 122,497,465 $ 180,403 $ 11,116 $ 8,348 $ 2,723 $ 11,071 $ 202,590 Balance – December 31, 2010 Issuance of shares under bought deal ﬁnancing, net of issuance costs Exercise of options Issuance of shares for property 14 a) Transfer of contributed surplus on exercise of options Share–based payments on option grants Income for the year Unrealized gain on translation of net investment Unrealized (loss) on translation to presentation currency on foreign operations Total comprehensive income for the year Balance – December 31, 2009 Issuance of shares under bought deal ﬁnancing, net of issuance costs Exercise of options Issuance of shares for property 14 a) Transfer of contributed surplus on exercise of options Share-based payments (recoveries) on option grants Income for the year Unrealized gain on translation to presentation currency on foreign operations Total comprehensive income for the year – – – – – – – – – – 2,441,700 6,756 (95) 3,751 30 – – – 2,451 (2,451) – – – – – – – – – – (95) 3,751 30 – – 19,533 1,830 19,533 751 751 751 (79) (79) (79) – – – – 1,830 – – 19,533 – – – – 26,507,500 999,500 7,813 73,919 1,004 20 – – – 759 (759) (2,440) – – 16,003 – – – – – – – – – – – – – 73,919 1,004 20 – – 16,003 (2,440) 16,003 – – 2,723 2,723 2,723 16,003 2,723 18,726 18,726 balance – december 31, 2011 124,945,921 $ 186,540 $ 10,495 $ 27,881 $ 3,395 $ 31,276 $ 228,311 19,533 672 20,205 20,205 94,982,652 $ 104,701 $ 14,315 $ (7,655) $ – $ (7,655) $ 111,361 – – – – – – – Balance – December 31, 2010 23 f) 122,497,465 $ 180,403 $ 11,116 $ 8,348 $ 2,723 $ 11,071 $ 202,590 The accompanying notes are an integral part of these consolidated ﬁnancial statements. 62 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 1. CORPORATE INFORMATION Fortuna Silver Mines Inc. (“Fortuna” or the “Company”) is engaged in silver mining and related activities, in Latin America, including exploration, extraction, and processing. The Company operates the Caylloma zinc/lead/silver mine in southern Peru and the San Jose silver/gold mine in Mexico. Fortuna is a publicly traded company incorporated and domiciled in Canada and is listed on the New York Stock Exchange under the trading ticker symbol “FSM”, and on the Toronto Stock Exchange and Lima Stock Exchange under the trading ticker symbol “FVI”. The Company’s registered ofﬁce is at Suite 650, 200 Burrard Street, Vancouver, British Columbia, Canada, V6C 3L6. 2. BASIS OF CONSOLIDATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES a) Statement of Compliance These consolidated ﬁnancial statements have been prepared in accordance with the International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). The policies applied in these consolidated ﬁnancial statements are based on IFRS issued and effective as at December 31, 2011. The Board of Directors approved these ﬁnancial statements for issue on March 23, 2012. b) basis of Consolidation These 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”); Fortuna Silver Mines Peru S.A.C. (“FSM Peru”); and Fortuna Silver Mexico, S.A. de CV. (“FS Mexico”). All signiﬁcant inter-company transactions, balances, revenues, and expenses have been eliminated upon consolidation. c) 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. Final commodity prices are set in a period subsequent to the date of sale based on a speciﬁed quotational period, either one or three months after delivery at the option of the customer or one month after delivery. The Company’s metal concentrates are provisionally priced at the time of sale based on the prevailing market price. Variations between the price recorded at the shipment date and the actual ﬁnal price set under the sales contracts are caused by changes in market prices, and result in an embedded derivative in accounts receivable. The embedded derivative is recorded at fair value each period until ﬁnal settlement occurs, with changes in fair value classiﬁed as provisional price adjustments and included in sales in the consolidated statement of income. Sales of metal concentrates are net of reﬁning and treatment charges. d) Cash and Cash equivalents Cash and cash equivalents are designated as fair value through proﬁt or loss (“FVTPL”). Cash and cash equivalents include cash on hand, demand deposits, and money market instruments, with maturities from the date of acquisition of 90 days or less, which are readily convertible to known amounts of cash and are subject to insigniﬁcant changes in value. Transaction costs are expensed when incurred through proﬁt or loss. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) e) Mineral Properties, Property, Plant and equipment Costs directly related to construction projects are capitalized to work-in-progress until the asset is available for use in the manner intended by management. Completed property, plant and equipment are recorded at cost, net of accumulated depreciation and accumulated impairments. Assets, other than capital work in progress, will be depreciated to their residual values over their estimated useful lives as follows: Land and buildings Land Mineral properties Buildings Leasehold improvements Plant and equipment Machinery and equipment Furniture and other equipment Transport units Not depreciated Units of production 6 – 20 years 7 – 8 years 3 – 8 years 3 – 13 years 4 – 5 years Straight line Straight line Straight line Straight line Straight line Capital work in progress Not depreciated Equipment under ﬁnance lease is initially recorded at the present value of minimum lease payments at the inception of the lease and depreciated as above. Spare parts and components included in machinery and equipment, depending on the replacement period of the initial component, are depreciated over 8 to 18 months. Borrowing costs allocable to the costs of construction projects are capitalized to mineral properties, property, plant and equipment and included in the carrying amounts of related assets until the asset is available for use in the manner intended by management. Costs associated with commissioning activities on constructed plants are deferred from the date of mechanical completion of the facilities until the date the assets are ready for use in the manner intended by management. On an annual basis, the depreciation method, useful economic life and the residual value of each component asset is reviewed, with any changes recognized prospectively over its remaining useful economic life. Evaluation and Exploration Assets i. 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. The Company defers the cost of acquiring, maintaining its interest, exploring and developing mineral properties as exploration and evaluation assets when future inﬂow of economic beneﬁts from the properties is probable and until such time as the properties are placed into development, abandoned, sold or considered to be impaired in value. If a mineable ore body is discovered, exploration and evaluation costs are reclassiﬁed to mining properties. 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. Proceeds received from the sale of interests in exploration and evaluation assets are credited to the carrying value of the mineral properties, with any excess included in income. Write-downs due to impairment in value are charged to income. The cash-generating unit for assessing impairment is a geographic region and shall be no larger than the operating segment. Exploration costs that do not relate to any speciﬁc property are expensed as incurred. Operational Mining Properties and Mine Development ii. For operating mines, all exploration within the mineral deposit is capitalized and amortized on a unit-of-production basis over proven and probable reserves as part of the production cost. Costs of producing properties are amortized on a unit-of-production basis over proven and probable reserves, and costs of abandoned properties are written-off. 64 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) iii. Commercial Production Capital work in progress consists of expenditures for the construction of future mines and include pre-production revenues and expenses prior to achieving commercial production. Commercial production is a convention for determining the point in time in which a mine and plant has completed the operational commissioning and has operational results that are expected to remain at a sustainable commercial level over a period of time, after which production costs are no longer capitalized and are reported as operating costs. The determination of when commercial production commences is based on several qualitative and quantitative factors including but not limited to the following: • all major capital expenditures to bring the mine to the condition necessary for it to be capable of operating in the manner intended by management have been completed; • the mine or mill is operating within eighty percent of design capacity; • metallurgical recoveries are achieved within eighty percent of projections; and, • the ability to sustain ongoing production of ore at a steady or increasing level. On the commencement of commercial production, depletion of each mining property will be provided on a unit-of- production basis. Any costs incurred after the commencement of production are capitalized to the extent they give rise to a future economic beneﬁt. f) asset impairment Assets are assessed for impairment at each reporting date when changes in events or circumstances occur that indicate the assets may not be recoverable. An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value less cost to sell and value in use. For the purposes of assessing impairment, assets are grouped at the lowest level for which there are separately identiﬁable cash inﬂows or cash generating units. These are typically individual mines or development projects. Brownﬁelds exploration projects, located close to existing mine infrastructure, are assessed for impairment as part of the associated mine cash generating unit. When the recoverable amount is assessed using pre-tax discounted cash ﬂow techniques, the resulting estimates are based on detailed mine and/or production plans. For value in use, recent cost levels are considered, together with expected changes in costs that are compatible with the current condition of the business. The cash ﬂow forecasts are based on best estimates of expected future revenues and costs, including the future cash costs of production, capital expenditure and reclamation and closures costs. Where a fair value less cost to sell model is used the cash ﬂow forecast includes net cash ﬂows expected to be realized from extraction, processing and sale of mineral resources that do not currently qualify for inclusion in proven or probable reserves. Where an impairment loss subsequently reverses, the carrying amount of the asset or cash-generating unit is increased to the revised estimate of recoverable amount, but not beyond the carrying amount that would have been determined had no impairment loss been recognized for the asset or cash-generating unit in prior years. A reversal of an impairment loss is recognized into earnings immediately. g) Provisions Decommissioning and restoration provisions i. Future obligations to retire an asset, including dismantling, remediation and ongoing treatment and monitoring of the site related to normal operations are initially recognized and recorded as a liability based on estimated future cash ﬂows discounted at a credit adjusted risk-free rate. The decommissioning and restoration provision (“DRP”) is adjusted at each reporting period for changes to factors including the expected amount of cash ﬂows required to discharge the liability, the timing of such cash ﬂows and the credit adjusted risk-free discount rate. The liability is accreted to full value over time through periodic charges to income. This accretion of provisions is charged to ﬁnance costs in the consolidated statements of income. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) The amount of the DRP initially recognized is capitalized as part of the related asset’s carrying value and amortized to income. The method of amortization follows that of the underlying asset. The costs related to a DRP are only capitalized to the extent that the amount meets the deﬁnition of an asset and can bring about future economic beneﬁt. For a closed site or where the asset which generated a DRP no longer exists, there is no longer future beneﬁt related to the costs and as such, the amounts are expensed. For operating sites, a revision in estimates or a new disturbance will result in an adjustment to the liability with an offsetting adjustment to the capitalized retirement cost. For closed sites, adjustments to the DRP that are required as a result of changes in estimates are charged to income in the period in which the adjustment is identiﬁed. Environmental disturbance restoration provisions ii. During the operating life of an asset, events such as infractions of environmental laws or regulations may occur. These events are not related to the normal operation of the asset and are referred to as environmental disturbance restoration provisions (“EDRP”). The costs associated with an EDRP are accrued and charged to earnings in the period in which the event giving rise to the liability occurs. Any subsequent adjustments to an EDRP due to changes in estimates are also charged to earnings in the period of adjustment. These costs are not capitalized as part of the long-lived asset’s carrying value. iii. Other provisions Provisions are recognized when a present legal or constructive obligation exists, as a result of past events, and it is probable that an outﬂow of resources that can be reliably estimated will be required to settle the obligation. Where the effect is material, the provision is discounted using an appropriate current market-based pre-tax discount rate. inventories h) Inventories include metals contained in concentrates, stockpiled ore, materials, and supplies. The classiﬁcation of metals inventory is determined by the stage in the production process. Product inventories 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. 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. income taxes i) Income tax expense consists of current and deferred tax expense. Income tax is recognized in the income or loss. Current tax expense is the expected tax payable on the taxable income for the year, using tax rates enacted or substantially enacted at period end, adjusted for amendments to tax payable with regards to previous years. Deferred tax assets and liabilities are recognized for deferred tax consequences attributable to unused tax loss carry forwards, unused tax credits and differences between the ﬁnancial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted or substantially enacted tax rates expected to apply when the asset is realized or the liability settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income or loss in the period that substantive enactment occurs. A deferred tax asset is recognized to the extent that it is probable that future taxable income will be available against which the asset can be utilized. To the extent that the Company does not consider it probable that deferred tax asset will be recovered, the deferred tax asset is reduced. The following temporary differences do not result in deferred tax assets or liabilities: • the initial recognition of assets or liabilities, not arising in a business combination, that does not affect accounting or taxable income; • goodwill; and, • investments in subsidiaries, associates and jointly controlled entities where the timing of reversal of the temporary differences can be controlled and reversal in the foreseeable future is not probable. Deferred tax assets and liabilities are offset when there is a legally enforceable right to the set off current tax assets against current tax liabilities and when they relate to income taxes levied by the same taxation authority and the Company intends to settle its current tax assets and liabilities on a net basis. 66 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Share-based Payments j) The fair value method of accounting is used for share-based payment transactions. Under this method, the cost of share options and other equity-settled share-based payment arrangements are recorded based on the estimated fair value at the grant date and charged to earnings over the vesting period. Where awards are forfeited because non-market based vesting conditions are not satisﬁed, the expense previously recognized is proportionately reversed in the period the forfeiture occurs. Share-based payment expense relating to cash-settled awards, including deferred and restricted share units is accrued over the vesting period of the units based on the quoted market value of Company’s common shares. As these awards will be settled in cash, the expense and liability are adjusted each reporting period for changes in the underlying share price. Stock Option Plan i. The Company applies the fair value method of accounting for all stock option awards. Under this method, the Company recognizes a compensation expense for all stock options awarded to employees, based on the fair value of the options on the date of grant which is determined by using the Black-Scholes option pricing model. The fair value of the options is expensed over the graded vesting period of the options. ii. Deferred Share Unit (“DSU”) Plan The Company’s DSU compensation liability is accounted for based on the number of units outstanding and the quoted market value of the Company’s common shares at the ﬁnancial position date. The year-over-year change in the deferred share unit compensation liability is recognized in income. iii. Restricted Share Unit (“RSU”) Plan The Company’s RSU compensation liability is accounted for based on the number of units outstanding and the quoted market value of the Company’s common shares at the ﬁnancial position date. The Company recognizes a compensation cost in operating income on a graded vesting basis for each RSU granted equal to the quoted 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 fair value until the end of the performance date. The cumulative effect of the change in fair value is recognized in income in the period of change. k) earnings (Loss) per Share Basic earnings (loss) per share is computed by dividing income for the year by the weighted average number of common shares outstanding during the period. The diluted earnings (loss) per share calculation is based on the weighted average number of common shares outstanding during the period, plus the effects of dilutive common share equivalents. This method requires that the dilutive effect of outstanding options 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. Foreign Currency Translation l) The presentation currency of the Company is the United States Dollar (“US$”). The functional currency of each of the entities in the group is the US$, with the exception of the parent entity and certain holding companies which have a Canadian dollar functional currency. Transactions in foreign currencies are initially recorded in the functional currency at the exchange rate at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are retranslated at the rate of exchange at each ﬁnancial position date. Foreign exchange gains or losses on translation to the functional currency of an entity are recorded in income. Non-monetary items that are measured in terms of historical cost in a foreign currency are translated using the exchange rate as at the date of the initial transaction. For entities with a functional currency different from the presentation currency, translation to the presentation currency is required. Assets and liabilities are translated at the rate of exchange at the ﬁnancial position date. Revenue and expenses are translated at the average rate for the period. All resulting exchange differences are recognized in other comprehensive income. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) m) Financial instruments Financial Assets i. The Company classiﬁes all ﬁnancial assets as either fair value through proﬁt or loss (“FVTPL”), held-to-maturity (“HTM”), loans and receivables, or available-for-sale “(AFS”). The classiﬁcation is determined at initial recognition and depends on the nature and purpose of the ﬁnancial asset. Financial Assets at Fair Value Through Proﬁt or Loss a) Financial assets are classiﬁed as FVTPL when the ﬁnancial asset is held-for-trading or it is a designated FVTPL on initial recognition. A ﬁnancial asset is classiﬁed in this category if acquired principally for the purpose of selling in the short- term. Financial assets classiﬁed as FVTPL are stated at fair value with any resulting gain or loss recognized in income or loss in the period in which they arise. Transaction costs related to ﬁnancial assets classiﬁed as FVTPL are recognized immediately in net income (loss). Derivatives are categorized as held-for-trading. Derivatives are initially recognized at fair value on the date a derivative contract is entered into and are subsequently remeasured at their fair value. Fair value of the Company’s recognized commodity-based derivatives are based on the forward prices of the associated market index. Gains or losses are recorded in the statement of income. b) Held-to-Maturity Investments (“HTM”) HTM investments are recognized on a trade-date basis and are initially measured at fair value, including transaction costs. The Company does not have any assets classiﬁed as HTM investments. Loans and Receivables c) Loans and receivables are non-derivative ﬁnancial assets with ﬁxed or determinable payments that are not quoted in an active market. They are stated at fair value, net of transaction costs and are classiﬁed as current or non-current assets based on their maturity date. They are carried at amortized cost less any impairment. The impairment loss of receivables is based on a review of all outstanding amounts at period end. Interest income is recognized by applying the effective interest rate, except for short term receivables when the recognition of interest would not be material. d) Available-For-Sale (“AFS”) Assets AFS ﬁnancial assets are non-derivatives that are either designated in this category or not classiﬁed in any of the other categories. AFS ﬁnancial assets are subsequently 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 statement of ﬁnancial position. Investments classiﬁed as available-for-sale are written down to fair value through income whenever it is necessary to reﬂect prolonged or signiﬁcant decline in the value of the assets. Realized gains and losses on the disposal of available-for-sale securities are recognized in investment and other income. The Company does not have any assets classiﬁed as AFS. Impairment of Financial Assets e) Financial assets, other than those at FVTPL, are assessed for indicators of impairment at each period end. Financial assets are impaired when there is objective evidence that, as a result of one or more events that occurred after the initial recognition of the ﬁnancial asset, the estimated future cash ﬂows of the investment have been impacted. Objective evidence of impairment could include the following: • signiﬁcant ﬁnancial difﬁculty of the issuer or counterparty; • default or delinquency in interest or principal payments; or • it has become probable that the borrower will enter bankruptcy or ﬁnancial reorganization. For ﬁnancial assets carried at amortized cost, the amount of the impairment is the difference between the asset’s carrying amount and the present value of the estimated future cash ﬂows, discounted at the ﬁnancial asset’s original effective interest rate. 68 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) The carrying amount of all ﬁnancial assets at amortized cost, excluding trade receivables, is directly reduced by the impairment loss. The carrying amount of trade receivables is reduced through the use of an allowance account. When a trade receivable is considered uncollectable, it is written off against the allowance account. Subsequent recoveries of amounts previously written off are credited against the allowance account. Changes in the carrying amount of the allowance account are recognized in income or loss. With the exception of AFS equity instruments, if a subsequent period, the amount of the impairment loss decreases and the decrease relates to an event occurring after the impairment was recognized, the previously recognized impairment loss is reversed through income or loss. On the date of impairment reversal, the carrying amount of the ﬁnancial asset cannot exceed its amortized cost had impairment not been recognized. Derecognition of Financial Assets f) A ﬁnancial asset is derecognized when: • the contractual right of the asset’s cash ﬂows expire; or • if the Company transfers the ﬁnancial asset and substantially all risks and reward of ownership to another entity. Financial Liabilities ii. Derivatives are categorized as held-for-trading. Derivatives are initially recognized at fair value on the date a derivative contract is entered into and are subsequently remeasured at their fair value. Fair value of the Company’s recognized commodity-based derivatives are based on the forward prices of the associated market index. Gains or losses are recorded in the statement of income. Long term debt and other ﬁnancial liabilities are recognized initially at the fair value, net of transaction costs incurred, and are subsequently stated at amortized cost. Any difference between the amounts originally received (net of transaction costs) and the redemption value is recognized in the income statement of income over the period to maturity using the effective interest method. iii. Classiﬁcation and Subsequent Measurements The Company has designated each of its signiﬁcant categories of ﬁnancial instruments as follows: Financial instrument Classiﬁcation Cash and Cash Equivalents Short Term Investments Derivative Assets Trade Receivable from Concentrate Sales Other Accounts Receivables Due from Related Parties Long Term Receivables Trade and Other Payables Due to Related Parties Derivative Liabilities Income Tax Payable Long Term Liabilities FVTPL FVTPL FVTPL FVTPL Loans and receivables Loans and receivables Loans and receivables Other liabilities Other liabilities FVTPL Other liabilities Other liabilities Measurement Fair value Fair value Fair value Fair value Amortized cost Amortized cost Amortized cost Amortized cost Amortized cost Fair value Amortized cost Amortized cost Effective Interest Method iv. The effective interest method calculates the amortized cost of a ﬁnancial instrument and allocates interest income or expense over the corresponding period. The effective interest rate is the rate that discounts estimated future cash receipts or payments over the expected life of the ﬁnancial instrument, or where appropriate, a shorter period, to the net carrying amount on initial recognition. Income or expense is recognized on an effective interest basis for instruments other than those ﬁnancial instruments classiﬁed as FVTPL. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) n) Segment Reporting A geographical segment is a distinguishable component of the entity that is engaged in providing products or services within a particular economic environment and is subject to risks and returns that are different than those of segments operating in other economic environments. The business operations comprise the mining and processing of silver-lead, zinc, and silver-gold and the sale of these products. o) Leases A lease is a ﬁnance lease when substantially all of the risks and rewards incidental to ownership of the leased asset are transferred from the lessor to the lessee by the agreement. The leased assets are initially recorded at the lower of the fair value and the present value of the minimum lease payments and are depreciated over the shorter of the asset’s useful lives and the term of the lease. Interest on the lease instalments is recognized as interest expense over the lease term using the effective interest method. Leases for land and buildings are recorded separately if the lease payments can be allocated accordingly. Leases that do not transfer all the risks and rewards of ownership are classiﬁed as operating leases. Payments are recorded in the income statement using the straight line method over their estimated useful lives. p) Share Capital Common shares are classiﬁed as equity. Incremental costs directly attributable to the issue of shares are shown in equity as a deduction from the proceeds. Share-based payments including stock option plan, deferred share unit plan, and restricted share unit plan are discussed in Note 2. j). q) Related Party Transactions Parties are considered to be related if one party has the ability directly, or indirectly, to control the other party or exercise signiﬁcant inﬂuence over the other party in making ﬁnancial and operating decisions. Parties are also considered to be related if they are subject to common control, related parties may be individuals or corporate entities. A transaction is considered to be a related party transaction when there is a transfer of resources or obligations between related parties. Signiﬁcant accounting judgments and estimates r) The preparation of consolidated ﬁnancial statements requires management to make judgments and estimates that affect the reported amounts of assets and liabilities at the date of the ﬁnancial statements and reported amounts of expenses during the reporting period. Actual outcomes could differ from these judgments and estimates. The consolidated ﬁnancial statements include judgments and estimates which, by their nature, are uncertain. The impacts of such judgments and estimates are pervasive throughout the consolidated ﬁnancial statements, and may require accounting adjustments based on future occurrences. Revisions to accounting estimates are recognized in the period in which the estimate is revised and the revision affects both current and future periods. Signiﬁcant assumptions about the future and other sources of judgments and estimates that management has made at the statement of ﬁnancial position date, that could result in a material adjustment to the carrying amounts of assets and liabilities, in the event that actual results differ from assumptions made, relate to, but are not limited to, the following: i. Critical Judgments • The analysis of the functional currency for each entity of the Company. In concluding that the United States dollar (“US$”) functional currency for its Peruvian and Mexican entities and the Canadian and Barbados entities have a Canadian dollar (“CAD$”) functional currency, management considered the currency that mainly inﬂuences the cost of providing goods and services in each jurisdiction in which the Company operates. As no single currency was clearly dominant the Company also considered secondary indicators including the currency in which funds from ﬁnancing activities are denominated and the currency in which funds are retained. • In concluding when commercial production has been achieved, the Company considered the following factors: • all major capital expenditures to bring the mine to the condition necessary for it to be capable of operating in the manner intended by management have been completed; • the mine or mill is operating as per design capacity and metallurgical recoveries were achieved; and, • the ability to sustain ongoing production of ore at a steady or increasing level. • The identiﬁcation of reportable segments, basis for measurement and disclosure of the segmented information. 70 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) • The determination of estimated useful lives and residual values of tangible and long-lived assets and the measurement of depreciation expense. • The identiﬁcation of impairment indicators, cash generating units and determination of value in use and the write down of tangible and long lived assets. • Measurement of ﬁnancial instruments involve signiﬁcant judgments related to interpretation of the terms of the instrument, identiﬁcation, classiﬁcation, impairment and the overall measurement to approximate fair values. ii. Estimates • the recoverability of amounts receivable which are included in the consolidated statements of ﬁnancial position; • the estimation of assay grades of metal concentrates sold in the determination of the carrying value of accounts receivable which are included in the consolidated statements of ﬁnancial position and included as sales in the consolidated statements of income; • the carrying value of the short term investments and the recoverability of the carrying value which are included in the consolidated statements of ﬁnancial position; • the determination of net realizable value of inventories on the consolidated statements of ﬁnancial position; • the estimated useful lives of property, plant and equipment which are included in the consolidated statements of ﬁnancial position and the related depreciation included in the consolidated statements of income; • the determination of mineral reserves, carrying amount of mineral properties, and depletion of mineral properties included in the consolidated statements of ﬁnancial position and the related depletion included in the consolidated statements of income; • review of tangible and intangible assets carrying value, the determination of whether these assets are impaired and the measurement of impairment charges or reversals which are included in the consolidated statements of income; • the determination of the fair value of ﬁnancial instruments and derivatives included in the consolidated statements of ﬁnancial position; • the fair value estimation of share-based awards included in the consolidated statements of ﬁnancial position and the inputs used in accounting for share-based compensation expense in the consolidated statements of income; • the provision for income taxes which is included in the consolidated statements of income and composition of deferred income tax asset and liabilities included in the consolidated statement of ﬁnancial position; • the recognition of deferred income tax assets, amounts recorded for uncertain tax positions, the measurement of income tax expense and indirect taxes included in the consolidated statement of ﬁnancial position; • the inputs used in determining the net present value of the liability for provisions related to decommissioning and restoration included in the consolidated statements of ﬁnancial position; • the inputs used in determining the various commitments and contingencies accrued in the consolidated statements of ﬁnancial position; and, • the assessment of indications of impairment of each mineral properties and related determination of the net realizable value and write-down of those properties where applicable. s) new accounting Standards The Company is currently assessing the impact of adopting the new accounting standards, noted below, on our consolidated ﬁnancial statements. i) New Accounting Standards Impacting on or after January 1, 2012 iFRS 7 Financial Instruments: Disclosures (Amendment) The amendment, effective for annual periods beginning on or after July 1, 2011, with early application permitted, requires additional quantitative and qualitative disclosures relating to transfers of ﬁnancial assets, where: ﬁnancial assets are derecognized in their entirety, but where the entity has a continuing involvement in them; ﬁnancial assets that are not derecognized in their entirety. iaS 12 Income Taxes (Amendment) IAS 12 Income Taxes, amendments regarding Deferred Tax: Recovery of Underlying Assets introduces an exception to the existing principle for the measurement of deferred tax assets and liabilities arising on investment property measured at fair value, and the requirement that deferred tax on non-depreciable assets measured using the revaluation model in IAS 16 should always be measured on a sale basis. The amendment is effective for annual periods beginning on or after January 1, 2012. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) ii) New Accounting Standards Impacting on or after July 1, 2012 iaS 1 Presentation of Financial Statements (Amendment) The amendments to IAS 1 Presentation of Financial Statements require companies preparing ﬁnancial statements in accordance with IFRSs to group together items within OCI that may be reclassiﬁed to the proﬁt or loss section of the income statement. The amendments retain the 'one or two statement' approach at the option of the entity and only revise the way other comprehensive income is presented: requiring separate subtotals for those elements which may be 'recycled' (e.g. cash-ﬂow hedging, foreign currency translation), and those elements that will not (e.g. fair value through OCI items under IFRS 9). In addition, the tax associated with items presented before tax to be shown separately for each of the two groups of OCI items (without changing the option to present items of OCI either before tax or net of tax). The amendment is effective for annual periods beginning on or after July 1, 2012. iii) New Accounting Standards Impacting on or after January 1, 2013 iFRS 7 Financial Instruments: Disclosures in Respect of Offsetting (Amendment) At its meeting on December 13-15, 2011, the IASB approved amendments to IFRS 7, Financial Instruments: Disclosures, with respect to offsetting ﬁnancial assets and ﬁnancial liabilities. The common disclosure requirements issued by the IASB and the FASB in December 2011 are intended to help investors and other users to better assess the effect or potential effect of offsetting arrangements on a company's ﬁnancial position. Companies and other entities are required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The required disclosures should be provided retrospectively. iFRS 10 Consolidated Financial Statements IFRS 10 Consolidated Financial Statements replaces the portion of IAS 27 Consolidated and Separate Financial Statements that addresses the accounting for consolidated ﬁnancial statements, and SIC12 Consolidation - Special Purpose Entities. IFRS 10 establishes principles for the presentation and preparation of consolidated ﬁnancial statements when an entity controls one or more entities. This standard (i) requires a parent entity (an entity that controls one or more other entities) to present consolidated ﬁnancial statements; (ii) deﬁnes the principle of control, and establishes control as a basis for consolidation; (iii) sets out how to apply the principle of control whether an investor controls an investee and therefore must consolidate the investee; and (iv) sets out the accounting requirements for the preparation of consolidated ﬁnancial statements. IFRS 10 is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. IFRS 10 may be adopted to an earlier accounting period, but in doing so, an entity must disclose the fact that it has early adopted the standard and apply IFRS 11 Joint Arrangements, IFRS 12 Disclosure of Interests in Other Entities, IAS 27 Separate Financial Statements (as amended in 2011), IAS 28 Investments in Associates and Joint Ventures (as amended in 2011). iFRS 11 Joint Arrangements IFRS 11 replaces IAS 31 Interest in Joint Ventures and SIC-13 Jointly-Controlled Entities-Non-Monetary Contributions by Venturers. This standard establishes the core principle that a party to a joint arrangement determines the type of joint arrangement in which it is involved by assessing its rights and obligations and accounts for those rights and obligations in accordance with that type of joint arrangement (joint operations or joint ventures). This standard is effective for annual periods on or after January 1, 2013, with early adoption permitted. iFRS 12 Disclosure of Interests in Other Entities IFRS 12 combines the disclosure requirements for an entity’s interest in subsidiaries, joint arrangements, associates and structured entities into one comprehensive disclosure standard. This standard requires the disclosure of information that enable users of ﬁnancial statements to evaluate the nature of, and risks associated with, its interest in other entities and the effects of those interests on its ﬁnancial position, ﬁnancial performance and cash ﬂows. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted, and entities are permitted to incorporate any of the new disclosures into their ﬁnancial statements before that date. 72 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) iFRS 13 Fair Value Measurement IFRS 13 Fair Value Measurement provides guidance on how to measure fair value, but does not change when fair value is required or permitted under IFRS. IFRS 13 deﬁnes fair value, sets out a single IFRS framework for measuring fair value and requires disclosures about fair value measurements. IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures about fair value measurements (and measurements, such as fair value less costs to sell, based on fair value or disclosures about those measurements), except for: share-based payment transactions within the scope of IFRS 2 Share-based Payment; leasing transactions with the scope of IAS 17 Leases; measurements that have some similarities to fair value that are not fair value, such as net realizable value in IAS 2 Inventories; or value in use IAS 36 Impairment of Assets. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. iaS 19 Post-employment Beneﬁts On June 16, 2011 the IASB issued amendments to IAS 19, Employee Beneﬁt, in order to improve the accounting for pensions and other post-employment beneﬁts. The amendments make important improvements by: • eliminating the option to defer the recognition of gains and losses, known as the ‘corridor method’ or the “deferral and amortization approach”; • streamlining the presentation of changes in assets and liabilities arising from deﬁned beneﬁt plans, including requiring re-measurements to be presented in OCI, thereby separating those changes from changes that many perceive to be the result of an entity’s day-to-day operations; • enhancing the disclosure requirements for deﬁned beneﬁt plans, providing better information about the characteristics of deﬁned beneﬁt plans and the risks that entities are exposed to through participation in those plans. The amendments are effective for ﬁnancial years beginning on or after January 1, 2013. Earlier application is permitted. iaS 27 Separate Financial Statements IAS 27 has the objective of setting standards to be applied in accounting for investments in subsidiaries, jointly controlled entities, and associates when an entity elects, or is required by local regulations, to present separate (non-consolidated) ﬁnancial statements. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. This standard will not have an impact on the consolidated ﬁnancial statements. iaS 28 Investments in Associates and Joint Ventures IAS 28 prescribes the accounting for investments in associates and to set the requirements for the application of the equity method when accounting for investments in associates and joint ventures. This standard is effective for annual periods beginning on or after January 1, 2013, with early adoption permitted. iv) New Accounting Standards Impacting on or after January 1, 2014 iaS 32 Financial Instruments - Presentation in Respect of Offsetting (Amendment) At its meeting on December 13-15, 2011, the IASB approved amendments to IFRS 7, Financial Instruments: Disclosures, with respect to offsetting ﬁnancial assets and ﬁnancial liabilities. As part of this project the IASB also clariﬁed aspects of IAS 32, Financial Instruments: Presentation. The amendments to IAS 32 address inconsistencies in current practice when applying the requirements. The amendments are effective for annual periods beginning on or after January 1, 2014 and are required to be applied retrospectively. v) New Accounting Standards Impacting on or after January 1, 2015 iFRS 9 Financial Instruments - Classiﬁcation and Measurement IFRS 9, Financial Instruments: IFRS 9 introduces the new requirements for the classiﬁcation, measurement and de- recognition of ﬁnancial assets and ﬁnancial liabilities. Speciﬁcally, IFRS 9 requires all recognized ﬁnancial assets that are within the scope of IAS 39 Financial Instruments: Recognition and Measurement to be subsequently measured at amortized cost or fair value, and all ﬁnancial liabilities classiﬁed as subsequently measured at amortized cost except for ﬁnancial liabilities as at FVTPL. The amendments are effective for annual periods beginning on or after January 1, 2015, with earlier application permitted. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 3. CASH AND CASH EQUIVALENTS Cash Cash equivalents december 31, 2011 december 31, 2010 january 1, 2010 $ 25,652 13,078 $ 61,118 9,180 $ 21,863 8,900 $ 38,730 $ 70,298 $ 30,763 Cash and cash equivalents include cash on hand, demand deposits, and money market instruments, with maturities from the date of acquisition of 90 days or less. 4. SHORT TERM INVESTMENTS Held for trading short term investments $ 17,000 $ 20,509 $ 6,034 Short term investments include deposits with maturities from the date of acquisition of more than 90 days. december 31, 2011 december 31, 2010 january 1, 2010 5. DERIVATIVE ASSETS AND DERIVATIVE LIABILITIES Lead Asian options Zinc Asian options Lead forward contracts Zinc forward contracts Silver forward contracts Total december 31, 2011 december 31, 2010 january 1, 2010 assets Liabilities assets Liabilities assets Liabilities $ – – – 70 – $ 70 $ – – 53 – 34 $ 87 $ – – – – – $ – $ – – 14 6 113 $ 133 $ 2 – – – 35 $ – 263 1,356 1,473 – $ 37 $ 3,092 The Company occasionally 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. As at the end of the year no such contracts are outstanding. Additionally, the Company enters regularly into short term forward and 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 forward sale and option contracts are settled against the arithmetic average of metal spot prices over the month in which the contract matures. No initial premium associated with these trades has been paid. 74 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 6. ACCOUNTS RECEIVABLE AND OTHER ASSETS AND DEPOSITS ON LONG TERM ASSETS The current accounts receivables and other assets are comprised of the following: Current Trade receivables from concentrate sales Current portion of long term receivables - net Prepaid expenses Deposits Advances and other receivables Accounts receivable and other assets GST/HST and value added tax receivable december 31, 2011 december 31, 2010 january 1, 2010 $ 11,287 891 1,171 47 2,213 $ 11,224 39 903 – 1,288 $ 15,609 $ 13,454 $ 4,777 $ 3,542 $ $ $ 7,154 121 313 24 1,023 8,635 601 Deposits on long term assets includes the non-current accounts receivable and other assets comprised of the following: december 31, 2011 december 31, 2010 january 1, 2010 non-current Long term receivables Less: current portion of long term receivables Non-current portion of long term receivables – net Deposits on equipment Deposits paid to contractors Other $ 1,415 $ (891) 524 1,167 448 121 47 (39) 8 3,097 1,581 – $ 2,260 $ 4,686 $ $ 137 (121) 16 – – – 16 As at December 31, 2011, the Company had $100 trade receivables (2010: $nil) (January 1, 2010: $nil) which were past due with no impairment. The Company’s allowance for doubtful accounts is $nil for all reporting periods. The aging analysis of these trade receivables is as follows: 0-30 days 31-60 days 61-90 days over 90 days december 31, 2011 december 31, 2010 january 1, 2010 $ 9,518 911 758 100 $ 9,754 1,057 413 – $ 7,154 – – – $ 11,287 $ 11,224 $ 7,154 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 7. INVENTORIES For the years ended December 31, 2011, $31,655 (2010: $22,270) of inventory was expensed in cost of sales and there has been no impairment during 2011 (2010: $nil). Concentrate stock piles Ore stock piles Materials and supplies Total inventories december 31, 2011 december 31, 2010 january 1, 2010 $ 2,488 4,008 4,795 $ 346 1,274 2,398 $ 651 203 1,474 $ 11,291 $ 4,018 $ 2,328 8. MINERAL PROPERTIES, PROPERTY, PLANT AND EQUIPMENT Mineral Properties non- depletable Mineral Properties depletable (Caylloma, San jose*) Land Machinery buildings, and Leasehold improvements and equipment Furniture and other equipment Transport units equipment under Finance Lease Capital Work in Progress Total year ended december 31, 2011 Opening carrying amount Additions Disposals Depreciation charge Impairment charge Reclassiﬁcation $ 49,129 6,258 – – – (48,076) $ 33,608 30,091 – (6,107) – 48,076 $ 6,897 5,429 (1,532) (1,847) (1,688) 10,057 $ 7,013 729 – (1,820) (195) 31,725 $ 3,177 2,032 (33) (334) – (1,657) $ 112 131 – (97) (11) – $ 2,893 500 – (873) – – $ 14,534 33,837 – – – (40,125) $ 117,363 79,007 (1,565) (11,078) (1,894) – Closing carrying amount $ 7,311 $ 105,668 $ 17,316 $ 37,452 $ 3,185 $ 135 $ 2,520 $ 8,246 $ 181,833 as at december 31, 2011 Cost Accumulated depreciation and impairment 7,311 125,667 $ 22,870 $ 41,212 $ 4,296 $ 520 $ 4,674 $ 8,246 $ 214,796 – (19,999) (5,554) (3,760) (1,111) (385) (2,154) – (32,963) Closing carrying amount $ 7,311 $ 105,668 $ 17,316 $ 37,452 $ 3,185 $ 135 $ 2,520 $ 8,246 $ 181,833 * Commercial production began on September 1, 2011 for San Jose and included in mineral properties non-depletable as at December 31, 2010 and January 1, 2010. In 2011, non-depletable mineral properties include the following properties: Mario, Don Mario, Tlacolula, and Taviche. Mineral Properties non- depletable Mineral Properties depletable (Caylloma) Land Machinery buildings, and Leasehold improvements and equipment Furniture and other equipment Transport units equipment under Finance Lease Capital Work in Progress Total Year ended December 31, 2010 Opening carrying amount Additions Disposals Depreciation charge Reclassiﬁcation $ 39,907 9,334 (112) – – $ 28,370 8,499 (443) (3,604) 786 $ 6,916 1,729 (20) (1,509) (219) $ 4,033 155 (1) (768) 3,594 $ 1,117 2,542 (10) (273) (199) Closing carrying amount $ 49,129 $ 33,608 $ 6,897 $ 7,013 $ 3,177 $ 197 88 (67) (106) – $ 112 $ 2,682 928 – (664) (53) $ 1,953 16,490 – – (3,909) $ 85,175 39,765 (653) (6,924) –- $ 2,893 $ 14,534 $ 117,363 As at December 31, 2010 Cost Accumulated depreciation and impairment 49,129 47,500 $ 11,060 $ 9,076 $ 3,985 $ 436 $ 4,174 $ 14,534 $ 139,894 – (13,892) (4,163) (2,063) (808) (324) (1,281) – (22,531) Closing carrying amount $ 49,129 $ 33,608 $ 6,897 $ 7,013 $ 3,177 $ 112 $ 2,893 $ 14,534 $ 117,363 76 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Mineral Properties non- depletable Mineral Properties depletable (Caylloma) Machinery and equipment Land and buildings Furniture and other equipment Transport units equipment under Finance Lease Capital Work in Progress Total As at January 1, 2010 Opening carrying amount Additions Disposals Depreciation charge Reclassiﬁcation $ 35,755 5,402 (1,250) – – $ 25,947 5,019 – (2,596) – $ 6,661 418 (77) (1,250) 1,164 $ 3,365 138 (1) (392) 923 $ 1,025 229 (26) (216) 105 Closing carrying amount $ 39,907 $ 28,370 $ 6,916 $ 4,033 $ 1,117 $ 392 – (80) (115) – $ 197 $ 1,629 1,425 (23) (349) – $ 1,493 2,652 – – (2,192) $ 76,267 15,283 (1,457) (4,918) – $ 2,682 $ 1,953 $ 85,175 As at January 1, 2010 Cost Accumulated depreciation and impairment 39,907 38,658 $ 9,933 $ 5,071 $ 1,548 $ 437 $ 3,249 $ 1,953 $ 100,756 – (10,288) (3,017) (1,038) (431) (240) (567) – (15,581) Closing carrying amount $ 39,907 $ 28,370 $ 6,916 $ 4,033 $ 1,117 $ 197 $ 2,682 $ 1,953 $ 85,175 Mineral properties includes bonuses paid of $1,350 (2010: $nil) (January 1, 2010: $nil) which were paid upon commissioning of the San Jose mine to a director, a director and ofﬁcer, and an ofﬁcer. The bonus comprises of $1,113 paid to key management and $237 paid to a company controlled by a director. Refer to Note 10 Related Party Transactions. a) Mario Property In May 2011, the Company entered into an agreement to acquire a 100% interest in the Mario Property, located in the Department of Junin in central Peru. Under the terms of the agreement, the Company is granted the exclusive right and option to purchase an undivided 100% interest in the Mario Property subject to the following payments: 1. $500 on signing of agreement; 2. $500 on or before six months from the signing of the agreement; 3. $500 on or before 12 months from the signing of the agreement; and, 4. $2,500 on or before 24 months from the signing of the agreement. The transfer of the property to the Company is subject to a 1% net smelter return (“NSR”) royalty on production from the property payable to Crocodile Gold (“Crocodile”). The Company shall have the right to purchase the NSR royalty from Crocodile at any time during the ﬁve-year period following the ﬁnal option payment for the sum of $3,000. The property is also subject to a 2% NSR royalty on production payable to Teck Cominco and a 0.5% NSR royalty on production payable to Socrate Capital Inc., with each royalty in turn subject to certain buy-back provisions. As at December 31, 2011, $1,000 has been paid under the agreement. b) don Mario Property The Company entered into an option agreement, effective July 20, 2011, to acquire 100% interest in the Don Mario property, with Consorcio Empresarial Agmin S.A.C.(“AGMIN”). Under the terms of the mining assignment and option to purchase mineral rights agreement (“agreement”), the Company is required to make the following payments: 1. $200 on signing the agreement; 2. $300 after 12 months from signing the agreement; 3. $500 after 24 months from signing the agreement; and, 4. $2,000 after 36 months from signing the agreement. Under the terms of the agreement, once the option is exercised and technical report is prepared under National Instrument 43-101 and published, if the pre-feasibility study indicates that the property contains more than ﬁve million silver equivalent ounces, the Company would further pay AGMIN, one dollar for each additional resource and reserves indicated in the pre-feasibility report. The Company has the option to buy-out the additional pay-out for a further $3,000, subject to certain conditions. As at December 31, 2011, $200 has been paid under the agreement. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 77 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Tlacolula Property c) 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 described further in Note 10). The Company can earn the Interest by spending $2,000, which includes a commitment to drill 1,500 meters within three years, and making staged annual payments of $250 cash and $250 in common stock of the Company to Radius according to the following schedule: • $20 cash and $20 cash equivalent in shares upon stock exchange approval; • $30 cash and $30 cash equivalent in shares by the ﬁrst year anniversary; • $50 cash and $50 cash equivalent in shares by the second year anniversary; • $50 cash and $50 cash equivalent in shares by the third year anniversary; and, • $100 cash and $100 cash equivalent in shares by the fourth year anniversary. Upon completion of the cash payments and share issuances, and 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 at a fair market value of $2.56 per share and paid $20 cash according to the terms of the option agreement. On January 14, 2011, the Company issued 6,756 common shares of the Company, at a fair market value of $4.44 per share and paid $30 cash according to the terms of the option agreement. Subsequent to December 31, 2011, on January 13, 2012, the Company issued 8,605 common shares of the Company, at a fair market value of $5.81 per share and paid $50 cash according to the terms of the option agreement. d) Taviche Property In 2010, the Company included the idle plant in Taviche as part of the San Jose mine plant as it was more likely than not that the idle plant could be used to treat excess ore from San Jose or from surrounding areas where the Company was conducting exploration. On September 1, 2011, the San Jose mine plant commenced commercial production and in the fourth quarter of 2011, achieved an average of 955 tonnes milled per day with the San Jose plant having sufﬁcient capacity for the production. In the fourth quarter, management reassessed the usability of the idle plant and in conjunction, obtained an independent third party appraisal of various assets acquired under an asset purchase agreement dated 2007 related to the Taviche property. Management used the fair value less cost to sell method to determine the recoverable amount of the idle plant. Based upon an independent appraisal of the assets, which is in accordance with fair value less cost to sell, the Company has taken an impairment charge of $1.89 million that comprised of the following impairments: $1.08 million on the tailing dam, $0.14 million on the mine infrastructure, and $0.67 million on equipment, machinery, and buildings. As at December 31, 2011, the net book value of assets related to the Taviche property for machinery, and equipment amount to $0.36 million. 9. TRADE AND OTHER PAYABLES Trade accounts payable Payroll and other payables Restricted share unit payable december 31, 2011 december 31, 2010 january 1, 2010 $ 8,800 7,152 1,204 $ 3,967 5,249 87 $ 2,580 2,556 – $ 17,156 $ 9,303 $ 5,136 78 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 10. RELATED PARTY TRANSACTIONS The consolidated ﬁnancial statements include the ﬁnancial statements of Fortuna Silver Mines Inc. and it subsidiaries listed in the following table: name Country of incorporation Minera Bateas S.A.C. Fortuna Silver Mines Peru S.A.C. Compania Minera Cuzcatlan SA Fortuna Silver Mexico, S.A. de CV Fortuna Silver (Barbados) Inc. Continuum Resources Ltd. Peru Peru Mexico Mexico Barbados Canada Fortuna Silver Mexico, S.A. de CV was incorporated in 2011. a) Purchase of goods and Services The Company entered into the following related party transactions: Transaction with related parties Salaries and wages 1, 2 Other general and administrative expenses 2 Leasehold improvements 2 equity interest as at december 31, 2011 100% 100% 100% 100% 100% 100% 2010 100% 100% 100% n/a 100% 100% year ended december 31 2011 173 292 93 558 $ $ 2010 174 185 – 359 $ $ 1 Salaries and wages includes employees' salaries and beneﬁts charged to the Company based on a percentage of the estimated hours worked for the Company. 2 Radius Gold Inc. (“Radius”) has directors in common with the Company and shares ofﬁce space, and is reimbursed for salaries and wages, general and administrative costs, and leasehold improvements incurred on behalf of the Company. During the year ended December 31, 2011, the Company transferred two mining concessions to Focus Ventures Ltd., a Company with directors in common, in exchange for a 1% net smelter return royalty. During the year ended December 31, 2011, the Company issued 6,756 (2010: 7,813) common shares, at a fair market value of $4.44 (2010: $2.56) per share and paid $30 cash (2010: $20) to Radius, under the option to acquire a 60% interest in Tlacolula silver project located in the State of Oaxaca, Mexico. Subsequent to the year ended December 31, 2011 to March 23, 2012, the Company issued 8,605 common shares, at a fair market value of $5.81 per share and paid $50 cash to Radius, under the option to acquire a 60% interest in Tlacolula silver project located in the State of Oaxaca, Mexico. b) Key Management Compensation Key management includes all persons named or performing the duties of Vice-President, Chief Financial Ofﬁcer, President, Chief Executive Ofﬁcer, and non-executive Directors of the Company. The compensation paid and payable to key management for services is shown below: Salaries and other short term employee beneﬁts Directors fees Consulting fees Share-based payments year ended december 31 2011 3,492 333 416 4,398 8,639 $ $ $ 2010 2,633 300 174 188 3,295 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 79 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) The share-based payments includes the change in the DSU and RSU fair value over each reporting period and payments made under the DSU and RSU plans and the non-cancellation of share options. Consulting fees includes fees paid to two non-executive directors in both 2011 and 2010. c) year-end balances arising from Purchases of goods/Services amounts due to/(from) related parties Owing from a director and ofﬁcer 3 Owing to a company with common directors 2 december 31, 2011 december 31, 2010 january 1, 2010 $ $ (36) 205 169 $ $ (1) 41 40 $ $ (1) 50 49 3 Owing from a director includes non-interest bearing advances to a director and ofﬁcers at December 31, 2011 and one ofﬁcer and director at December 31, 2010 and January 1, 2010. 11. LEASES AND LONG TERM LIABILITIES Leases and long term liabilities are comprised of the following: Obligations under ﬁnance lease (a) Long term liability (b) Deferred share units (Note 14 c)) Restricted share units (Note 14 d)) Less: current portion Obligations under ﬁnance lease Long term liability Current portion of long term liability Restricted share unit payable, current (Note 9) december 31, 2011 december 31, 2010 january 1, 2010 $ 866 771 2,639 1,204 5,480 741 771 1,512 1,204 $ 1,545 705 1,955 131 4,336 1,083 – 1,083 87 $ 1,848 644 – – 2,492 1,038 – 1,038 – Leases and long term liability, non-current $ 2,764 $ 3,166 $ 1,454 a) obligations under Finance Lease The following is a schedule of the Company’s future minimum lease payments. These are related to the acquisition of mining equipment, vehicles, and buildings. obligations under Finance Lease Not later than 1 year Less: future ﬁnance charges on ﬁnance lease Later than 1 year but less than 5 years Less: future ﬁnance charges on ﬁnance lease Present value of ﬁnance lease payments december 31, 2011 december 31, 2010 january 1, 2010 $ $ 763 (22) 741 126 (1) 125 866 $ 1,150 $ (67) 1,083 472 (10) 462 1,151 (113) 1,038 862 (52) 810 $ 1,545 $ 1,848 b) Long Term Liabilities In May 2008, the Company acquired the Monte Alban II concession for which a payment of $800 is due May 2012. This payment is non-interest bearing. 80 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 12. PROVISIONS A summary of the Company’s provisions for other liabilities and charges is presented below: Balance – January 1, 2010 New provisions Increase to existing provisions Accretion of provisions (Note 20) Foreign exchange differences Balance – December 31, 2010 Increase to existing provisions Accretion of provisions (Note 20) Foreign exchange differences Cash payments Total provisions – december 31, 2011 Less: current portion non current – december 31, 2011 decommissioning and Restoration Liability $ $ $ $ 2,917 1,583 125 163 93 4,881 126 173 (5) (201) 4,974 (727) 4,247 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 decommissioning and restoration liability relating to the Caylloma and San Jose 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 properties, property, plant and equipment balance. 13. INCOME TAX a) Income tax expense differs from the amount that would be computed by applying the Canadian statutory income tax rate of 26.50% (2010: 28.50%) to income before income taxes. The reasons for the differences are as follows: Income before tax Statutory income tax rate Expected income tax Items non-deductible for income tax purposes Difference between Canadian and foreign tax rates Effect of change in tax rates Impact of foreign exchange on tax assets and liabilities Impact of Mexican inﬂation on tax values Under (over) provided in prior periods Unused tax losses and tax offsets not recognized in tax asset Total income taxes Represented by: Current income tax Deferred income tax december 31 2011 december 31 2010 $ 38,335 26.50% $ 10,159 1,401 1,376 620 3,271 (16) 704 1,287 $ 27,513 28.50% $ 7,841 292 874 431 (133) (130) (1,495) 3,830 $ 18,802 $ 11,510 $ 14,607 4,195 $ 8,620 2,890 $ 18,802 $ 11,510 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 81 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) The effective tax rate for the years ended December 31, 2011 and 2010 was 49.05% and 41.8%, respectively. The change in the effective tax rate was primarily attributable to the geographical mix of income, ﬂuctuations in exchange rates for foreign currency, the impact of foreign exchange on the tax basis on non-monetary assets, and the non- recognition of tax beneﬁts. Effective January 1, 2011, the Canadian Federal corporate tax rate decreased from 18% to 16.5% and the British Columbia provincial tax decreased from 10.5% to 10%. The overall reduction in tax rates has resulted in a decrease in the Company’s statutory tax rate from 28.50% to 26.50%. In 2009, the Mexican government approved tax reform that includes a 2% increase in the income tax rate in Mexico from 28% to 30% for a three-year period starting in 2010. Income taxes payable of $3,923 (December 31, 2010: $4,192, January 1, 2010 $2,949) relates to current taxes. b) The tax effected items that give rise to signiﬁcant portions of the deferred income tax assets and deferred income tax liabilities at December 31, 2011 and 2010 are presented below: Deferred income tax assets: Non-capital losses Provisions and other Financial derivatives Mineral properties, property, plant and equipment Net deferred income tax assets Deferred income tax liabilities: Mineral properties – Peru Mineral properties – Mexico Equipment Total deferred income tax liabilities Net deferred income tax liabilities Classiﬁcation Non-current assets Non-current liabilities december 31 2011 december 31 2010 $ 12,544 2,059 5 296 14,904 $ $ $ $ (11,790) (5,640) (10,148) (27,578) (12,674) 36 (12,710) $ $ $ $ $ 2,939 1,095 42 186 4,262 (9,912) (2,832) – (12,744) (8,482) – (8,482) Net deferred income tax liabilities $ (12,674) $ (8,482) c) The Company recognizes tax beneﬁts on losses or other deductible amounts generated in countries where the probable criteria for the recognition of deferred tax assets has been met. The Company’s unrecognized deductible temporary differences and unused tax losses for which no deferred tax asset is recognized consist of the following amounts: Non-capital losses Provisions and other Share issue cost Mineral properties, property, plant and equipment Unrecognized deductible temporary differences december 31 2011 december 31 2010 $ 38,503 3,841 2,913 1,532 $ 29,689 3,563 4,146 3,966 $ 46,789 $ 41,364 82 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) The Company’s unrecognized deferred tax assets related to unused tax losses have the following expiry dates: Non-capital losses, expiring as follows: Canada Mexico Barbados 14. SHARE CAPITAL expiry date 2013 - 2031 2016 - 2031 2017 - 2020 $ 35,346 2,850 172 $ 38,368 a) unlimited Common Shares Without Par Value 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: 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. During the year ended December 31, 2011, the Company issued 6,756 (2010: 7,813) common shares, at a fair market value of $4.44 (2010: $2.56) per share to Radius Gold, under the option to acquire a 60% interest in Tlacolula silver project located in the State of Oaxaca, Mexico. Subsequent to the year ended December 31, 2011 to March 23, 2012, the Company issued 8,605 common shares, at a fair market value of $5.81 per share to Radius Gold, under the option to acquire a 60% interest in Tlacolula silver project located in the State of Oaxaca, Mexico. b) Share options The Company’s stock option plan, approved by the shareholders on August 30, 2006 and accepted by the TSX Venture Exchange on October 16, 2006 provides a rolling maximum of the issuance of common treasury shares equal to up to ten percent of the issued and outstanding common shares with no vesting provisions. The exercise price of the optioned shares are no less than the market price, with a maximum term of ten years from grant. Shareholder approval of the Company’s stock option plan was not obtained at the Company’s annual general meeting held on June 23, 2010. Shareholder approval of the Company’s new Stock Option Plan (the “New Plan”), dated April 11, 2011, was obtained at the Company’s annual general meeting held on May 26, 2011. The New Plan provides that the number of common shares of the Company issuable under the Plan, together with all of the Company’s other previously established or proposed share compensation arrangements, may not exceed 12,200,000 shares, which equals 9.92% of the current total number of issued and outstanding common shares of the Company, as at April 11, 2011. Option pricing models require the input of highly subjective assumptions including the estimate of the share price volatility, risk-free interest rate and expected life of the options. Changes in the subjective input assumptions can materially affect the fair value estimate. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 83 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) The following is a summary of option transactions: Outstanding at beginning of the year Granted Exercised Cancelled Forfeited Outstanding at end of the year Vested and exercisable at end of the year december 31, 2011 december 31, 2010 Shares (in 000’s) 4,551 1,792 (2,442) – (25) 3,876 2,557 Weighted average exercise price (Cad$) $ 1.51 4.46 1.55 – 4.46 $ 2.83 $ 1.99 Shares (in 000’s) 8,215 – (999) (2,665) – 4,551 4,551 Weighted average exercise Price (Cad$) $ 1.50 – 1.03 1.62 – $ 1.51 $ 1.51 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. During the year ended December 31, 2011, 1,792,289 share purchase options were granted with an exercise price of CAD$4.46 per share with a term of three years and vesting 25% within six months of grant date, 50% within 12 months of grant date, 75% within 18 months of grant date, and fully vested after 24 months of grant date. As at December 31, 2011, 24,814 share purchase options were forfeited and 8,271 share purchase options were accelerated to expire March 8, 2012. The share based compensation charge of $1,830 covering option grants, forfeitures, and accelerated vesting, was recognized for the year ended December 31, 2011 has been determined under the fair value method using the Black-Scholes option pricing model with the following assumptions: Risk-free interest rate Expected stock price volatility Expected term in years Expected dividend yield Expected forfeiture rate year ended december 31 2011 1.91% 56.48% 3 0% 1.38% 2010 n/a n/a n/a n/a n/a The expected volatility assumption is based on the historical volatility of the Company’s Canadian dollar common share price on the Toronto Stock Exchange. The following table summarizes information related to stock options outstanding and exercisable at December 31, 2011: exercise price in Cad$ $0.80 to $0.99 $1.00 to $1.99 $2.00 to $4.46 $0.80 to $4.46 number of outstanding share purchase options (in 000’s) 816 693 2,367 3,876 Weighted average remaining contractual life of outstanding share purchase options (years) Weighted average exercise price on outstanding share purchase options Cad$ exercisable share purchase options (in 000’s) Weighted average exercise price on exercisable share purchase options Cad$ 6.8 4.4 3.0 4.1 $ 0.85 1.53 3.90 $ 2.83 816 693 1,048 2,557 $ 0.85 1.53 3.19 $ 1.99 Subsequent to December 31, 2011 to March 23, 2012, 184,138 share purchase options were granted with an exercise price of CAD$6.67 per share with a term of ﬁve years and vesting 33.33% within twelve months of grant date, 33.33% within 24 months of grant date, and 33.34% within thirty six months of grant date. 84 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Subsequent to December 31, 2011, 49,628 share purchase options were forfeited and 41,542 share purchase options were accelerated to expire March 30, 2012. Subsequent to December 31, 2011 to March 23, 2012, 314,225 share purchase options were exercised at prices ranging from CAD$0.85 to CAD$4.46 per share, resulting in issued and outstanding shares of 125,268,751. c) deferred Share units (“dSu”) Cost During 2010, the Company implemented a DSU 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. During the year ended December 31, 2011, 70,000 DSU were settled in cash for $5.36 per unit for a total payment of $375. During the year ended December 31, 2011, the Company granted 48,824 DSU with a market value of CAD$232, at the date of grant, to a director, and 93,544 DSU with a market value of CAD$473, at the date of grant, to a director, with vesting subject to the commissioning of the San Jose mine, which occurred on September 1, 2011. During the year ended December 31, 2010, the Company granted 409,097 DSU with a market value of CAD$1,358, at the date of grant, to directors. As at December 31, 2011, there are 481,465 (2010: 409,097) DSU outstanding with a fair value of $2,639 (2010: $1,955). d) Restricted Share units (“RSu”) Cost During 2010, the Company implemented a RSU plan for certain employees or ofﬁcers. The RSU entitle employees or ofﬁcers to a cash payment after the end of a performance period of 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 RSU held by the employee. During the year ended December 31, 2011, the Company granted 155,674 RSU with a market value of CAD$788, at the date of grant, to a director, with vesting subject to the commissioning of the San Jose mine, which occurred on September 1, 2011. During the year ended December 31, 2011, the Company paid $736 (2010: $nil) on 109,557 (2010: nil) RSU to directors, a former director, and ofﬁcers of the Company. As at December 31, 2011, there are 265,231 (2010: 219,114) RSU outstanding with a fair value of $1,204 (2010: $131). e) earnings per Share Basic i. Basic earnings per share is calculated by dividing the income for the year by the weighted average number of shares outstanding during the year. The following table sets forth the computation of basic earnings per share: Income available to equity owners Weighted average number of shares (in '000's) Earnings per share – basic year ended december 31 2011 2010 $ 19,533 $ 16,003 123,295 108,120 $ 0.16 $ 0.15 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 85 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) ii. Diluted Diluted earnings per share is calculated by adjusting the weighted average number of shares outstanding to assume conversion of all potentially dilutive shares. The following table sets forth the computation of diluted earnings per share: Income available to equity owners Weighted average number of shares ('000's) Incremental shares from share options Weighted average diluted shares outstanding Earnings per share – diluted year ended december 31 2011 2010 $ 19,533 $ 16,003 123,295 1,417 124,712 108,120 2,445 110,565 $ 0.16 $ 0.14 15. SUPPLEMENTAL CASH FLOW INFORMATION Non-cash Investing and Financing Activities: Issuance of shares on purchase of mineral properties, property, plant and equipment 8 $ 30 $ 20 note years ended december 31 2011 2010 16. 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 equity and available credit facility, 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, 2011, are sufﬁcient for its present needs for at least 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. 17. MANAGEMENT OF FINANCIAL RISK The Company’s ﬁnancial instruments are exposed to certain ﬁnancial risks, including currency risk, credit risk, liquidity risk, interest risk, and price risk. The Company’s Board of Directors has overall responsibility for the establishment and oversight of the Company’s risk management framework and reviews the Company’s policies on an ongoing basis. a) Fair Value of Financial instruments The carrying value of cash and cash equivalents, short term investments, derivative assets, trade receivable from concentrate sales, other accounts receivables, trade and other payables, due to related parties, and derivative liabilities 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. The amortized value of long term receivables approximates their fair value as these are measured at the amortized cost using the effective interest method. The fair value of the lease and long term liabilities is $5,531 as at December 31, 2011. 86 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 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 trade receivable from concentrate sales, 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. Financial assets (liabilities) at fair value as at december 31, 2011 Level 1 Level 2 Level 3 Total Cash and cash equivalents Short term investments Trade receivable from concentrate sales Derivatives $ $ 38,730 17,000 – – – – 11,287 (17) $ $ 55,730 $ 11,270 $ – – – – – $ 38,730 17,000 11,287 (17) $ 67,000 There were no changes in the levels during the year ended December 31, 2011. Financial assets (liabilities) at fair value as at december 31, 2010 Level 1 Level 2 Level 3 Total Cash and cash equivalents Short term investments Trade receivable from concentrate sales Derivatives $ $ 70,298 20,509 – – – – 12,551 (133) $ $ 90,807 $ 12,418 $ – – – – – $ 70,298 20,509 12,551 (133) $ 103,225 There were no changes in the levels during the year ended December 31, 2010. Accounts receivable includes trade receivable from concentrate sales, provisional price adjustments, and ﬁnal price adjustments. 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. As such, these accounts receivable are classiﬁed within level 2 of the fair value hierarchy. 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, 2011, there have been no changes in the classiﬁcation of ﬁnancial assets and liabilities in levels 1, 2, and 3 of the hierarchy. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 87 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 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 and Mexico 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 income, ﬁnancial position, or cash ﬂows. The Company has not hedged its exposure to currency ﬂuctuations. As at December 31, 2011, 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 Accounts receivable and other assets Deposits on long term assets Trade and other payables Provisions, current Income tax payable Leases and long term liabilities Provisions december 31, 2011 Canadian dollars nuevo Soles Mexican Pesos Canadian dollars december 31, 2010 nuevo Soles Mexican Pesos $ 18,457 42 – (1,580) – – (2,691) – S/. 1,396 5,657 – (17,993) (1,351) (10,581) – (8,079) $ 1,758 58,939 – (24,310) (3,163) – – (17,494) $ 54,782 71 – (625) – – (1,999) – S/. 741 1,304 – (15,493) – (11,775) – (9,169) $ 2,201 42,452 24,209 (6,390) – – – (19,959) Total 14,228 (30,951) 15,730 52,229 (34,392) 42,513 Total US$ equivalent 13,950 (11,476) 1,125 52,219 (12,244) 3,440 Based on the above net exposure as at December 31, 2011, 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, as follows: impact to other comprehensive income of $1,550 (2010: $5,802) and a net loss of $1,150 (2010: $978). 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. The Company’s maximum exposure to credit risk at December 31, 2011 is as follows: Cash and cash equivalents Short term investments Accounts receivable Derivative assets Due from related parties GST/HST and value added tax receivable december 31 2011 december 31 2010 $ 38,730 17,000 14,391 70 36 4,777 $ 70,298 20,509 12,551 – – 3,542 $ 75,004 $ 106,900 The carrying amount of ﬁnancial assets recorded in the ﬁnancial statements represents the Company’s maximum exposure to credit risk. The Company believes it is not exposed to signiﬁcant credit risk and overall, the Company’s credit risk has not declined signiﬁcantly from the prior year. 88 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 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), ﬁnance leases, and other contractual commitments: Trade and other payables Due to related parties Derivative liabilities Income tax payable Long term liabilities Operating leases Provisions expected payments due by period as at december 31, 2011 Less than 1 year $ 17,156 205 87 3,923 1,534 696 734 $ 24,335 1–3 years 4–5 years $ – – – – 2,765 1,410 849 $ 5,024 $ – – – – – 1,177 774 $ 1,951 after 5 years $ – – – – – 531 3,725 $ 4,256 Total $ 17,156 205 87 3,923 4,299 3,814 6,082 $ 35,566 Operating leases includes leases for ofﬁce premises, computer and other equipment used in the normal course of business. Refer to Note 19 c) for details of operating leases. 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. In the event that utilization under the credit facility is less than $10 million, a commitment fee of 1.50% per annum is payable quarterly on the unutilized portion of the available credit facility. No funds were drawn from this credit facility during the year. interest Rate Risk e) 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. A 10% change in interest rates would cause a $12 change in income on an annualized basis. f) Metal Price Risk The Company is exposed to metals price risk with respect to silver, gold, zinc, lead, and copper sold through its mineral concentrate products. The Company mitigates this risk by implementing price protection programs for some of its zinc and lead production through the use of derivative instruments. As a matter of policy, the Company does not hedge its silver production. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 89 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 18. SEGMENTED INFORMATION All of the Company’s operations are within the mining sector, conducted through operations in three countries. Due to geographic and political diversity, the Company’s mining operations are decentralized whereby management are responsible for achieving speciﬁed business results within a framework of global policies and standards. Country corporate ofﬁces provide support infrastructure to the mine in addressing local and country issues including ﬁnancial, human resources, and exploration support. Products are silver, gold, lead, zinc and copper produced from mines in Peru and Mexico. Segments have been aggregated where operations in speciﬁc regions have similar products, production processes, types of customers and economic environment. The Company’s operating segments are based on the reports reviewed by the senior management group that are used to make strategic decisions. The Chief Executive Ofﬁcer considers the business from a geographic perspective considering the performance of the Company’s business units. The segment information provided to the Board of Directors for the reportable segments for the year ended December 31, 2011 and 2010 are as follows: Reportable Segments Corporate bateas Cuzcatlan Total Year ended December 31, 2011 Sales to external customers $ Silver concentrates Gold concentrates Lead concentrates Zinc concentrates Copper concentrates Sales to internal customers Cost of sales Depreciation, depletion, and amortization Selling, general and administrative expenses Exploration and evaluation costs Impairment of mineral properties, property, plant and equipment Interest income Interest expense Income (loss) before tax Income taxes Income (loss) for the year Capital expenditures $ – – – – – – 5,961 – 100 14,352 1,715 – 494 306 (15,881) 183 (16,064) 814 97,740 – – 80,689 15,290 1,761 – 42,236 7,053 3,920 – – 297 219 52,133 15,804 36,329 25,066 $ 12,264 7,586 4,678 – – – – 6,794 2,268 1,568 – 1,894 39 35 2,083 2,815 (732) 53,127 $ 110,004 7,586 4,678 80,689 15,290 1,761 5,961 49,030 9,421 19,840 1,715 1,894 830 560 38,335 18,802 19,533 79,007 90 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Reportable Segments Corporate bateas Cuzcatlan Total Year ended December 31, 2010 Sales to external customers $ Lead concentrates Zinc concentrates Copper concentrates Sales to internal customers Cost of sales Depreciation, depletion, and amortization Selling, general and administrative expenses Exploration and evaluation costs Interest income Interest expense Income (loss) before tax Income taxes Income (loss) for the year Capital expenditures $ – – – – 2,464 – 202 6,941 547 44 417 (6,491) (47) (6,444) 1,190 74,056 31,180 15,883 26,993 – 34,844 6,347 4,043 – 449 291 34,004 11,557 22,447 14,614 $ $ – – – – – – – – – – – – – – 23,961 74,056 31,180 15,883 26,993 2,464 34,844 6,549 10,984 547 493 708 27,513 11,510 16,003 39,765 Reportable Segments Corporate bateas Cuzcatlan Total as at december 31, 2011 Total assets Total liabilities As at December 31, 2010 Total assets Total liabilities As at January 1, 2010 Total assets Total liabilities $ $ $ $ $ $ 27,843 5,694 81,900 3,404 25,330 321 $ $ $ $ $ $ 112,746 29,793 74,950 24,794 65,439 21,037 $ $ $ $ $ $ 131,017 7,808 77,020 3,082 42,820 870 $ $ $ $ $ $ 271,606 43,295 233,870 31,280 133,589 22,228 For the years ended December 31, 2011 three (2010: two) customers, respectively, represented 100% of total sales to external customers. external Sales by Customer and Region Customer 1 Customer 2 Bateas/Peru % of total sales Customer 1 Cuzcatlan/Mexico % of total sales Consolidated % of total sales $ $ $ $ $ 2011 95,978 1,762 97,740 89% 12,264 12,264 11% 110,004 100% 98% 2% 100% 100% 100% 100% years ended december 31, $ $ $ $ $ 2010 47,062 26,994 74,056 100% – – 0% 74,056 100% 64% 36% 100% 0% 0% 100% FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 91 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 19. CONTINGENCIES AND CAPITAL COMMITMENTS a) bank Letter of guarantee The Caylloma mine closure plan was approved in November 2009 with total closure costs of $3,587 of which $1,756 is subject to annual collateral in the form of a letter of guarantee, to be awarded each year in increments of $146 over 12 years 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 $439. This bank letter of guarantee expires 360 days from December 2011. 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 were renewed in June 2011 with expiry 360 days to June 2012. b) Capital Commitments As at December 31, 2011, $8,122 of capital commitments not disclosed elsewhere in the consolidated ﬁnancial statements, and forecasted to be expended within one year, includes the following: $5,800 for the ramp development at the San Jose property located in Mexico; $2,247 for the tailing dam, concentrator plant and electrical infrastructure renewal, and mine camp development at the Caylloma Property; and $75 for software development. c) other Commitments 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 3,500 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 and expiring in 2017. 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 ﬁnance lease obligations held by two of its mining contractors. These ﬁnance lease contracts are related to the acquisition of mining equipment deployed at the Caylloma mine. As at December 31, 2011, these obligations amounted to $231 with $74 maturing in 2012 and $157 maturing in 2013. The Company, jointly with Radius Gold Inc., has entered into an ofﬁce premise lease located in Canada, effective on November 28, 2011, the date the Company commenced carrying on business in the premises. The shared ofﬁce with Radius has been ﬁnalized with the Company obligated to pay 50% of the total rent payable. The lease term is eight years with the Company’s annual net rent payable, on 3,195 rentable square feet, as follows: • years one to two $111; • years three to ﬁve $115; and, • years six to eight $118. In addition, estimated operating costs, utilities, and realty taxes is $71 in the ﬁrst year of occupancy. During 2011, the Company has advanced 50% of the three month security deposit in the amount of $47. On May 24, 2010, the Company entered into a seven year ofﬁce premise lease located Peru. The annual rent payable on 1,717 rentable square meters for ofﬁce space, is as follows: • year one $289; • year two $297; • year three $306; and, • years four through seven the lease is subject a minimum annual increase of 3% or the Consumer Price Index published by Bureau of Labor Statistics of the United States Department of Labor, whichever is higher. The lease also includes the use of additional space for mini-warehouse and parking spots, the obligation for which is $58 per annum for the ﬁrst year and is subject to an annual increase of 3% as stated above until the end of the lease. As at December 31, 2011, the Company has advanced rent $159 (2010:$426) and provided a security deposit of $44. On March 15, 2011, the Company entered into a one year ofﬁce premise lease located in Mexico with an annual lease obligation of $37. The ofﬁce premise leases are included as operating leases in Note 17 d). 92 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Ofﬁce premises – Canada Ofﬁce premises – Peru Ofﬁce premises – Mexico Total ofﬁce premises Computer equipment – Peru Computer equipment – Mexico Total computer equipment Total operating leases Less than 1 year $ 181 363 8 $ 552 128 16 $ 144 $ 696 expected payments due by period as at december 31, 2011 1–3 years 4–5 years $ 549 758 – $ 1,307 75 28 $ 103 $ 1,410 $ 372 805 – $ 1,177 – – – $ $ 1,177 $ 531 after 5 years $ 359 172 – $ 531 – – – $ Total $ 1,461 2,098 8 $ 3,567 203 44 $ 247 $ 3,814 d) other Contingencies In February 2009, the Environmental Assessment and Oversight Agency (“OEFA”) in Peru, alleged the Company had ﬁve violations: two were for breaches of recommendations; two for excess of total suspended solids in water over the maximum allowable; and an alleged unauthorized discharge of efﬂuent. The Ministry of Energy and Mines in Peru (“OSINERGMIN”) decided to close the two alleged violations for failure to adopt recommendations and punish the Company for the three alleged violations and imposed a ﬁne of $200 in 2010. The Company appealed on June 23, 2010. Subsequent to December 31, 2011 and on February 22, 2012, the alleged unauthorized discharge of efﬂuent was dismissed and conﬁrmed a ﬁne of $133 for the two alleged violations of excess of total suspended solids in water over the maximum allowable. The Company is proceeding with an administrative appeal to the Ministry of Energy and Mines in Peru (“OSINERGMIN”) for the remaining two alleged offenses. The Company believes it is more likely than not that it will defend itself successfully in the claims and therefore has not recorded a provision for the potential exposure relating to these alleged violations. 20. NET FINANCE INCOME (EXPENSE) Finance income Interest income on FVTPL ﬁnancial assets Total ﬁnance income Finance expenses Interest expense Standby and commitment fees Accretion of provisions (Note 12) Total ﬁnance expense net ﬁnance income (expense) years ended december 31 2011 2010 $ $ 830 830 81 306 173 560 270 $ 493 493 128 417 163 708 $ (215) FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 93 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 21. EXPENSES BY NATURE Cost of Sales Direct mining costs 1 Depreciation and depletion Royalty expenses Total cost of sales years ended december 31 2011 2010 $ 38,649 9,059 1,322 $ 27,729 6,327 788 $ 49,030 $ 34,844 1 Direct mining costs includes salaries and other short term beneﬁts, contractor charges, energy, consumables and production related costs. Selling, general and administrative expenses Salaries and beneﬁts Corporate administration Audit, legal and professional fees Filing and listing fees Director's fees Depreciation years ended december 31 $ 2011 12,168 3,409 2,915 467 519 362 $ 2010 5,312 2,253 2,414 311 472 222 Total selling, general and administrative expenses $ 19,840 $ 10,984 exploration and evaluation costs Brownﬁelds exploration Greenﬁelds exploration Evaluation costs $ 2011 206 344 550 1,165 $ Total exploration and evaluation costs $ 1,715 $ 2010 160 253 413 134 547 years ended december 31 22. SUBSEQUENT EVENTS UP TO MARCH 23, 2012 Subsequent to December 31, 2011 and at March 23, 2012 the value of the DSU and RSU liabilities have increased by $278 and $211, respectively. On February 17, 2012, the Company entered into a one year ofﬁce premise lease, effective March 1, 2012, located in Mexico with an annual lease obligation of $18. 94 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) 23. FIRST-TIME ADOPTION OF IFRS IFRS 1 First-time Adoption of International Financial Reporting Standards, which governs the ﬁrst time adoption of IFRS, in general requires accounting policies to be applied retrospectively to determine the opening ﬁnancial position at the Company’s transition date of January 1, 2010, and allows certain exemptions on the transition to IFRS. The elections the Company has decided to apply and that are considered signiﬁcant to the Company include: • business Combinations exemption – IFRS 1 allows a ﬁrst-time adopter to not apply of IFRS 3 retrospectively to business combinations that occur before either the date of transition to IFRS or an alternative pre-transition date. – The Company elected the business combinations exemption in IFRS 1 to not apply IFRS 3 retrospectively to past business combinations. Accordingly, the Company has not restated business combinations that took place prior to the transition date. • Share-based Payment exemption – IFRS 1 gives a ﬁrst-time adopter the option to not apply IFRS 2 Share-Based Payment to (i) equity instruments that were granted for the periods on or before November 7, 2002 or after November 7, 2002 but that vested before the date of transition to IFRS and (ii) liabilities arising from cash-settled share-based payment transactions if those liabilities were settled before January 1, 2005 or before the date of transition to IFRS. – The Company elected to apply this exemption at the transition date. • Cumulative Translation differences – IFRS 1 gives a ﬁrst-time adopter through 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. – The Company elected to set the previously accumulated cumulative translation amount, which was included in accumulated other comprehensive income (“AOCI”), to zero as at the date of transition with the balance being reclassiﬁed to retained earnings. • borrowing Costs exemption – This exemption in IFRS 1 allows a ﬁrst-time adopter to apply the transitional provisions set out in IAS 23 Borrowing Costs at January 1, 2009 or the date of transition to IFRS, whichever is later. IAS 23 requires the capitalization of borrowing costs related to all qualifying assets. – The Company elected to apply IAS 23 to borrowing costs relating to all qualifying assets for which the commencement date for capitalization is on or after the transition date. • decommissioning Liability exemption – IFRS 1 indicates that a ﬁrst-time adopter may elect not to apply IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities retrospectively. – The Company elected to take a simpliﬁed approach to calculate and record the asset related to the decommissioning and restoration liability on our opening IFRS consolidated statement of ﬁnancial position. The decommissioning and restoration liability calculated on the transition date in accordance with IFRS 37 Provisions, Contingent Liabilities and Contingent Assets was discounted back to the date when the provision ﬁrst arose on the mineral property, at which date the corresponding asset and liability was set up and then depreciated to its carrying amount at the transition date. The IFRS 1 mandatory exceptions applied by the Company in the conversion from Canadian Generally Accepted Accounting Principles (“CAD GAAP”) to IFRS included estimates. In accordance with IFRS 1, an entity’s estimates under IFRS at the date of transition to IFRS must be consistent with estimates made for the same date under previous GAAP unless those estimates were in error. The Company’s IFRS estimates as at the Transition Date are consistent with its CAD GAAP estimates as at that date. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 95 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) Adjustments on transition to IFRS Adoption of IFRS resulted in changes to the Company’s Statements of Financial Position, Statements of Income, Statements of Comprehensive Income (Loss), Statements of Cash Flows, and Statements of Changes in Equity as set out below: a) Foreign exchange Under IAS 21, each entity in a group must be analyzed, through application of primary and secondary factors, to determine its functional currency. Based on this assessment, the functional currency of each of the entities in the group is the US$, with the exception of the parent entity and certain holding companies which have a Canadian dollar functional currency. Under CAD GAAP, the parent entity had a Canadian dollar presentation currency and all subsidiaries were integrated with the exception of Bateas which was self-sustaining. The presentation currency will continue to be US$. The parent entity and the holding companies which have a CAD$ functional currency will be translated to US$ using the closing rate method with the differences to the cumulative translation adjustment account, on consolidation. Those entities with a US$ functional currency do not require translation on consolidation. Under CAD GAAP, the Company used the indirect consolidation method whereby all entities were ﬁrst translated to CAD$ and then the entire consolidation translated to US$ for presentation purposes. b) deferred income Tax Under IFRS, income taxes include all domestic and foreign taxes based on taxable proﬁts. The Company accounted for Peruvian statutory workers participation under CAD GAAP as an income tax. Under IFRS the statutory workers participation is accounted for as an employee beneﬁt under IAS 19. Accordingly, future Peruvian Workers Participation balances have been derecognized and current Peruvian Workers Participation expense has been reclassiﬁed from income tax expense to operating expenses. Under IFRS, deferred tax is recognized on the difference between the accounting basis and tax basis of all items. Under CAD GAAP income tax assets or liabilities were not recognized for differences arising between the historical exchange rate and the current exchange rate translation of the cost of non-monetary assets or liabilities of integrated foreign operations. For foreign currency non-monetary assets or liabilities where the tax basis currency differs from the functional currency of the entity, foreign exchange differences will result in tax assets or liabilities which were not previously recognized under CAD GAAP. This difference will result in added volatility in the tax expense as foreign exchange rate changes will have an impact on the tax expense. IAS 12 does not permit recognition of temporary differences on the initial acquisition of assets that do not constitute a business combination. There is no similar prohibition under CAD GAAP. Deferred tax arising from temporary differences on initial recognition have been reversed against mineral properties, property, plant and equipment and retained earnings. c) Reset accumulated other Comprehensive income to Zero The Company has taken the exemption under IFRS 1 which allows for the cumulative translation differences that existed at the date of transition to IFRS to be reset to zero. d) Provisions Where a provision is recognized, IFRS requires the estimate to be discounted at a risk-free pre-tax rate, typically that of a government bond that is matched to the expected risk adjusted cash ﬂows. On transition, the Company used a risk free rate to discount their decommissioning liabilities and this results in an increased decommissioning liability being recognized under IFRS as compared to CAD GAAP. 96 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) e) Reclassiﬁcation of items in the Consolidated Statements of income The Company has reclassiﬁed the following income and expense items in the consolidated statements of income: • government royalties to cost of sales from selling, general and administrative expenses; • distribution costs to cost of sales from selling, general and administrative expenses; • community relation costs to cost of sales from selling, general and administrative expenses; • other income and expenses from interest and other income and expenses to selling, general and administrative expenses; • interest expense includes interest on debt ﬁnancing and accretion of provisions; • current workers participation from income tax to cost of sales and selling, general and administrative expenses; and, • depletion and depreciation combined with cost of sales. In addition, exploration and evaluation costs moved from selling, general and administrative expenses. The above changes are reclassiﬁcations within our statement of income so there is no net impact to our income as a result of these changes. f) Reconciliation of Consolidated Statements of Changes in equity The reconciliations between the CAD GAAP and IFRS consolidated Equity, for January 1, 2010 and December 31, 2010 are provided below: expressed in $’000’s Equity, CAD GAAP Adjustments: Effect of foreign exchange on inventory, deposits on long term assets, and mineral properties, property, plant and equipment Deferred income tax adjustments Transfer of accumulated other comprehensive income to retained earnings Reset accumulated other comprehensive income to zero Adjustment to revise provisions Adjustment for depletion on mineral properties related to provisons Total iFRS adjustments to equity equity, iFRS notes january 1, 2010 december 31, 2010 $ 112,557 $ 206,008 23 a) 23 b) 23 c) 23 c) 23 d) 23 d) (2,538) 1,475 2,898 (2,898) (311) 178 (1,196) (5,339) 1,944 2,898 (2,898) (254) 231 (3,418) $ 111,361 $ 202,590 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 97 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) g) Reconciliation of Consolidated Statement of Financial Position The reconciliations between the CAD GAAP and IFRS consolidated statement of ﬁnancial position at December 31, 2010 (date of transition to IFRS) are provided below. notes Canadian gaaP december 31, 2010 effect of Transition to iFRS iFRS $ 70,298 20,509 13,454 3,542 4,034 111,837 $ – – – – (16) (16) $ 70,298 20,509 13,454 3,542 4,018 111,821 23 a) 23 a) 4,533 153 4,686 23 a) b) d) 126,813 (9,450) 117,363 $ 243,183 $ (9,313) $ 233,870 $ 9,303 40 133 4,192 1,083 14,751 3,166 4,924 14,334 37,175 180,403 11,116 3,597 10,892 14,489 206,008 $ – – – – – – – (43) (5,852) (5,895) – – 4,751 (8,169) (3,418) (3,418) $ 9,303 40 133 4,192 1,083 14,751 3,166 4,881 8,482 31,280 180,403 11,116 8,348 2,723 11,071 202,590 $ 243,183 $ (9,313) $ 233,870 aSSeTS CuRRenT aSSeTS Cash and cash equivalents Short term investments Accounts receivable and other assets GST/HST and value added tax receivable Inventories non-CuRRenT aSSeTS Deposits on long term assets Mineral properties, property, plant and equipment Total assets LiabiLiTieS and eQuiTy CuRRenT LiabiLiTieS Trade and other payables Due to related parties Derivative liabilities Income tax payable Current portion of long term liability non-CuRRenT LiabiLiTieS Leases and long term liabilities Provisions Deferred income tax liabilities 23 d) 23 b) d) eQuiTy Share capital Share option and warrant reserve Retained earnings (deﬁcit) Accumulated other comprehensive income 23 a) b) c) d) 23 c) 98 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) h) Reconciliations of Consolidated Statement of income The reconciliation between the CAD GAAP and IFRS consolidated statement of income for the year ended December 31, 2010 are provided below: Sales Cost of sales Mine operating income (loss) other expenses notes 23 e) 23 d) e) Canadian gaaP $ 74,056 29,129 44,927 $ Selling, general and administrative expenses Exploration and evaluation costs Net (gain) on commodity contracts Loss on disposal of mineral properties, property, 23 a) e) 23 e) plant and equipment Loss on disposal of investment Write-off of deferred exploration costs 16,529 547 (736) 127 119 443 year ended december 31, 2010 effect of Transition to iFRS – 5,715 (5,715) (5,545) – – – – – iFRS $ 74,056 34,844 39,212 10,984 547 (736) 127 119 443 operating income (loss) Finance items Interest income Interest expense net ﬁnance income (expense) income before tax Income taxes income for the year 27,898 (170) 27,728 23 d) e) 23 e) 23 b) d) e) (379) (544) (923) 26,975 14,020 872 (164) 708 538 (2,510) 493 (708) (215) 27,513 11,510 $ 12,955 $ 3,048 $ 16,003 i) Reconciliation of Consolidated Statement of Comprehensive income The reconciliation between the CAD GAAP and IFRS consolidated statement of comprehensive income for the year ended December 31, 2010 are provided below: notes Canadian gaaP year ended december 31, 2010 effect of Transition to iFRS iFRS Income for the year Other comprehensive income (loss) Transfer of unrealized loss to realized loss upon reduction of net investment, net of taxes Unrealized (loss) gain on translation to 23 c) presentation currency on foreign operations 23 a) Other comprehensive (loss) income $ 12,955 $ 3,048 $ 16,003 2,100 5,895 7,994 (2,100) (3,172) (5,271) – 2,723 2,723 Total comprehensive (loss) income for the year $ 20,949 $ (2,223) $ 18,726 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT 99 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FoR THe yeaRS ended deCeMbeR 31, 2011 and 2010 (all amounts in uS$’000’s unless otherwise stated) j) Reconciliation of Consolidated Statement of Cash Flows The adoption of IFRS has had no material impact on the net cash ﬂows of the Company. The changes made to the Consolidated Statement of Financial Position and Consolidated Statement of Comprehensive Income has resulted in reclassiﬁcations of various amounts on the Consolidated Statement of Cash Flows, however as there have been no material changes to the net cash ﬂows, summarized reconciliation has been presented below. Effect of exchange rate changes on cash and cash equivalents (deCReaSe) inCReaSe in CaSH and CaSH eQuiVaLenTS Cash and cash equivalents – beginning of year notes 23 a) 23 a) Canadian gaaP 2,128 37,407 30,763 CaSH and CaSH eQuiVaLenTS – end oF yeaR $ 70,298 $ year ended december 31, 2010 effect of Transition to iFRS 23 (23) – – iFRS 2,151 37,384 30,763 $ 70,298 100 FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT CAYLLOMA MINE Trading on the NYSE as of September 19, 2011 CORPORATE DATA Corporate Office Suite 650 – 200 Burrard Street Vancouver, BC Canada V6C 3L6 Tel: +1.604.484.4085 Management Head Office Piso 5. Av. Jorge Chávez #154 Miraflores, Lima – Perú Tel: +51.1.616.6060, ext. 0 Investor Relations Management Head Office Carlos Baca, Investor Relations Manager Corporate Office Holly Hendershot, Investor Relations info@fortunasilver.com Stock Exchanges NYSE: FSM TSX: FVI BVL: FVI Frankfurt: F4S.F Legal Counsel Blake Cassels & Graydon LP Suite 2600 – 595 Burrard Street Vancouver, BC Canada V7X 1L3 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 2T8 Qualified Person Thomas I. Vehrs, Ph.D., Vice President of Exploration, is the Qualified Person for Fortuna Silver Mines Inc. as defined by National Instrument 43-101. Dr. Vehrs is a Founding Registered Member of The Society for Mining, Metallurgy, and Exploration, Inc. (SME Registered Member Number 3323430RM) and is responsible for ensuring that the information contained in this annual report is an accurate summary of the original reports and data provided to or developed by Fortuna Silver Mines. FORTUNA SILVER MINES INC. 2011 ANNUAL REPORT www.fortunasilver.com Caylloma Mine, Peru Frankfurt: F4S.F www.fortunasilver.com PRINTED IN CANADA DESIGN BY XY3 DESIGN

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