2007 Financial Report

Transcription

1 2007 Financial Report

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3 Message to Shareholders In 2007 Breakwater continued to execute its business plan. We are less than two years into our long-term plan which is to invest in capital and exploration as required to secure a long-term future for the assets that warrant that investment and grow our production profile. Our exploration success is evident as our mineral reserves grew by 35% and the measured and indicated resources grew by 22%. This was accomplished with only a 5% reduction in inferred resources. This growth is largely due to the results of the very successful programs at Toqui and Langlois which are in line with our expectations and confirm management s belief in the organic growth opportunities of our assets. These results do not yet reflect the exploration success we have had with our joint venture partner, Virginia Mines Inc. at the Coulon project in northern Québec. Our exploration success is evident as our mineral reserves grew by 35% and the measured and indicated resources grew by 22%. Breakwater grew its production profile this year with the achievement of commercial production at Langlois, as scheduled, at the end of June. This operation was brought on stream with higher production than anticipated due to the development of Grevet B, a satellite ore body, which provides incremental mill feed. The forecast of a 62% increase in zinc production in 2008 reflects the full year activities at Langlois. The forecast of a 62% increase in zinc production in 2008 reflects the full year activities at Langlois. During the year, Mochito experienced a set back at the new tailings impoundment facility, however, this situation was managed to a very satisfactory outcome. The remediation of Soledad is progressing on schedule and this tailings facility will be augmented with a paste plant which, when combined with other design changes, should result in the elimination of any future failures. Our continued investment in Mochito reflects the importance of the operation to Breakwater and our belief in the long-term prospects of the property. We expect that our exploration efforts will secure a robust future for Mochito FINANCIAL REPORT BREAKWATER RESOURCES LTD. 1

4 At Toqui, the operational results were on target and the growth in resources reflects and confirms our belief that this is an asset with tremendous potential. The underlying geological system is very large and we continue to add to our understanding of the mineral endowment of the region. Our pre-feasibility study to determine if the operation can be expanded to one million tonnes per year is expected to be delivered by mid-year. Myra Falls continues to present challenges. The level of expenditure dropped during the year as the operation failed to deliver on its operating and exploration plan. The mine model was overly focused on reducing unit costs through increasing tonnage and therefore throughput. This plan was not successful and consequently, we have refocused on mining fewer tonnes at higher grade. The future of the site continues to lie with the development of the western extensions of the mine and we are currently accessing those areas. The decision to write down the carrying value of Myra Falls was in recognition of the high operating costs and limited exploration success to date. Our pre-feasibility study to determine if the operation can be expanded to one million tonnes per year is expected to be delivered by mid-year. The long-term fundamentals for zinc look very positive. Although the analysts are calling for a balanced market in 2008 and surpluses in 2009, the outlook for 2010 and beyond is very good. There simply are not enough good projects in advanced exploration or development stages to feed the projected demand from China and India in this time period. The markets will remain volatile but we will continue to execute on our long-term plan. We are financially sound and are well positioned to continue to grow through increases in production and through exploration success. We wish to thank our directors for their guidance, our employees for their efforts and our shareholders for their support. It is through these three groups that we continue to build a company who will continue to do the right things right. George E. Pirie President and Chief Executive Officer March 11, BREAKWATER RESOURCES LTD FINANCIAL REPORT

5 Management s Discussion and Analysis of Financial Condition And Results Of Operations This management s discussion and analysis of financial condition and results of operations ( MD&A ) of Breakwater Resources Ltd. (the Company ) should be read in conjunction with the Company s audited consolidated financial statements for the year ended December 31, 2007, and related notes thereto which have been prepared in accordance with Canadian generally accepted accounting principles ( GAAP ). Unless otherwise indicated, this MD&A has been prepared as of February 29, The reporting currency is Canadian dollars ( C$ or $ ) and all amounts disclosed are in Canadian dollars unless otherwise indicated. Unless the context indicates otherwise, a reference to the Company in this MD&A means Breakwater Resources Ltd. and its subsidiaries and other entities owned or controlled, directly or indirectly, by the Company. The Company is a mining, exploration and development company which produces zinc, copper, lead and gold concentrates. During 2007, the Company s concentrate production was derived from mines located in Canada, Chile and Honduras. The Company also owns base metal and gold exploration properties in Canada, Honduras, Tunisia and Chile. The Langlois mine, located in Canada, began production in November 2006 and commenced commercial production for accounting purposes on July 1, The start-up of the Langlois mine affects all aspects of the Company s financial results which makes comparisons between years difficult. HIGHLIGHTS The Company realized net earnings of $23.4 million or $0.06 per share in 2007 compared with $156.5 million or $0.41 per share in 2006, the $133.1 million decrease was primarily due to: $35.0 million write-down of Myra Falls, comprising a $16.0 million write-down relating to the value of the mineral properties and fixed assets and a $19.0 million write-down of future tax assets related to the impairment write-down following a review triggered by lower metal prices and higher operating costs $7.6 million of unrealized losses due to the valuation of conversion rights in certain convertible debentures held by the Company primarily due to lower share prices and the marking to market of available-for-trade securities $3.2 million provision for tailings facility modification at Myra Falls $13.8 million gain on sale of the Caribou property in 2006 $47.9 million (US$16.6 million) lower gross sales revenue primarily due to a 7% decrease in concentrate sold, a 7% appreciation of the C$ and a 4% decrease in the realized prices of each of zinc and copper in 2007 compared with 2006 $27.0 million increase in direct operating costs primarily due to similar aggregate costs at Myra Falls and Mochito despite 31% and 22% fewer tonnes sold respectively and the impact of Langlois $7.0 million increase in exploration expenses $15.5 million future tax asset for Langlois established in 2007 Aggregate production increased to 288,083 tonnes from 252,513 tonnes primarily due to Langlois and increased production at Toqui partially offset by lower production at Myra Falls and Mochito. Successfully renegotiated new three year contracts at Toqui and Mochito and overcame a breach at a newly commissioned tailings impoundment at Mochito to resume normal production. The Company also commenced a pre-feasibility study at Toqui to support a 1.0 million tonne per annum mill and earned a 50% interest in the Coulon property. The Company entered into a $20.0 million qualifying environmental trust to fully fund estimated reclamation and closure obligations at Myra Falls and issued $12.0 million of flow-through shares to fund a portion of the 2008 exploration program. Reserves and Resources On February 28, 2008, the Company released its 2007 mineral reserve and mineral resource statement to the public. References in this MD&A to 2007 mineral reserves and resources should be read in conjunction with that news release FINANCIAL REPORT BREAKWATER RESOURCES LTD. 3

6 MANAGEMENT S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management is responsible for establishing and maintaining adequate control over financial reporting. Management conducted an evaluation of the effectiveness of internal control over financial reporting based on Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company s internal control over financial reporting was effective as at December 31, OUTLOOK On February 28 and 29, 2008, the Company released its 2008 projections for tonnes milled, metal grades, concentrate produced, payable metals, capital expenditures, operating costs and exploration expenses to the public. References to production outlooks in this MD&A should be read in conjunction with those news releases. SENSITIVITY TO METAL PRICES, ZINC SMELTER TREATMENT CHARGES AND EXCHANGE RATES The Company s cash flow and net earnings are sensitive to the movement in a variety of prices and costs and are particularly sensitive to movements in the price of zinc, smelter treatment charges and the US$/C$ exchange rate. The following table provides the Company s estimates of the sensitivity of net income to changes in the various metal prices, zinc smelter treatment charges and US$/C$ exchange rate movements based on projections for The Company s projection for 2008 is based on a US$/C$ exchange rate of $ and zinc, lead, copper, gold and silver prices of US$1.00 per pound, US$1.30 per pound, US$3.40 per pound, US$750 per ounce and US$13.75 per ounce respectively. The sensitivity table assumes that all other prices and/or the exchange rate are held constant. Sensitivity Variable Change ($millions) Zinc +/-10% per pound +/-$22.6 Copper +/-10% per pound +/-$6.3 Lead +/-10% per pound +/-$3.7 Gold +/-10% per ounce +/-$2.8 Silver +/-10% per ounce +/-$3.2 Exchange rate +/-10% US$/C$ -$26.4/+$21.6 Zinc smelter treatment charges +/-10% -/+$5.6 SELECTED ANNUAL INFORMATION Statement of Operations and Statement of Cash Flow Data Years ended December 31, ($ millions except for share and per share numbers) Gross sales revenue Treatment and marketing costs Net revenue Total operating costs Contribution from mining activities Net earnings Basic earnings per Common Share Diluted earnings per Common Share Net cash provided by operating activities Capital expenditures Basic weighted-average number of Common Shares outstanding (000 s) 413, ,748 Number of Common Shares outstanding (000 s) 425, ,646 4 BREAKWATER RESOURCES LTD FINANCIAL REPORT

7 Balance Sheet Data As at December 31, ($ millions) Cash and cash equivalents Working capital Total assets Total debt Total long-term liabilities Shareholders equity STATEMENT OF OPERATIONS REVIEW 2007 AND 2006 Gross Sales Revenue Sales of concentrate fluctuate period to period due to production levels, shipping volumes, ship schedules, price determination terms, and risk and title transfer terms with the Company s various customers. The Company has a relatively conservative revenue recognition policy (see below) and the recognition of sales can be as much as six months after the date of concentrate production. The Company s sales are primarily denominated in United States dollars ( US$ ). Concentrate Sold (tonnes) Zinc: Mochito 58,426 78,962 Toqui 67,825 51,926 Myra Falls 50,243 86,458 Langlois (1) 17, , ,346 Copper Myra Falls 26,523 25,120 Langlois (1) 2,846 29,369 25,120 Lead Mochito 16,054 16,310 Toqui ,054 16,556 Gold Toqui 4,313 2,703 Myra Falls ,316 2,727 All Metals 244, ,749 (1) Langlois entered commercial production on July 1, Net cash flow from concentrate produced at Langlois prior to July 1, 2007 reduced preproduction capital expenditures FINANCIAL REPORT BREAKWATER RESOURCES LTD. 5

8 Concentrate Realized Gross sales Concentrate Realized Gross sales sold Payable price (1) revenue sold Payable price (1) revenue (tonnes) metal (1) (US$) ($000s) (tonnes) metal (1) (US$) ($000s) Zinc 194,311 82,661 3, , ,346 93,897 3, ,399 Copper 29,369 6,207 6,959 43,193 25,120 5,442 7,217 39,270 Lead 16,054 10,162 2,508 25,481 16,556 10,611 1,297 13,757 Gold 4,316 44, ,225 2,727 42, ,578 Silver n.a. 2,127, ,429 n.a. 2,070, ,287 Other (2) n.a. (1,011) n.a. (207) 244, ,749 Gross sales revenue in US$ 381, ,084 Exchange rate Gross sales revenue in C$ 404, ,233 (1) Payable metal and realized prices for zinc, copper and lead are per tonne and for gold and silver are per ounce. (2) Other gross sales revenue represents revaluations of prior period concentrate receivables. Concentrate sold in 2007 decreased 7% to 244,050 tonnes. The 17,699 tonne decrease was due to decreases of 31% at Myra Falls and 22% at Mochito which more than offset 31% higher sales at Toqui and sales of 20,663 tonnes at Langlois. In payable metal terms, copper, gold and silver sales were 14%, 5% and 3% higher respectively while zinc and lead sales declined by 12% and 4% respectively. Lead, gold and silver prices, denominated in US$, increased by 93%, 26% and 30% respectively in 2007 compared with 2006 while prices for zinc and copper sales decreased by 4% each. Gold and silver hedging losses of US$1.4 million (US$33 per ounce) and US$2.4 million (US$1.18 per ounce) respectively were included in the 2006 prices. The Company periodically hedges against fluctuations in metal prices and foreign exchange rates using forward sales or options. The Company has not applied hedge accounting historically; therefore, mark-to-market gains or losses have been included in gross sales revenue at the end of each year. There were no hedges in place in 2007 and accordingly no hedging gains or losses. Gross sales revenues decreased US$16.6 million or 4% in 2007 compared with A rising C$ resulted in an increase in the average exchange rate of the US$/C$ of 7% in 2007 compared with In C$ terms, gross sales revenue decreased $47.9 million or 11% in 2007 compared with The Company s revenue recognition policy requires that, among other things, final pricing of concentrate inventories be known prior to the recognition of revenue. Using commodity prices and exchanges rates prevailing at December 31, 2007, the following schedule provides details regarding inventories shipped but not recognized for revenue purposes and the related provisional payments. Net smelter Inventory Earnings Provisional Weighted- Concentrate return value before taxes payments average months (DMT) ($000 s) ($000 s) ($000 s) ($000 s) to settlement Zinc 38,831 25,659 22,015 3,644 19, Copper 5,970 8,928 8, , Lead 5,345 10,190 7,408 2,782 11, Gold 954 3,014 1,121 1, ,100 47,791 39,383 8,408 32,248 As at December 31, 2006, the Company estimated that inventories shipped but not recognized for revenue purposes had earnings before tax of $18.1 million consisting of $38.3 million of net smelter return less $20.2 million of inventory value on 25,499 tonnes of concentrate. 6 BREAKWATER RESOURCES LTD FINANCIAL REPORT

9 The following table provides the average base and precious metal prices and exchange rates for the periods indicated. Average Metal Prices & Exchange Rate Zinc (US$/tonne) 3,242 3,275 Copper (US$/tonne) 7,114 6,720 Lead (US$/tonne) 2,578 1,289 Gold (US$/ounce) Silver (US$/ounce) C$/US$ exchange rate Treatment and Marketing Costs Treatment and marketing costs decreased 22% to $100.3 million in 2007 from $127.8 million in 2006 while 7% fewer tonnes of concentrate were sold. Treatment and marketing costs as a percentage of gross sales revenue in 2007 were 25% compared with 28% in The decrease in treatment and marketing costs as a percentage of revenue was primarily due to lower zinc and copper prices which resulted in lower escalators (the upside price participation by smelters) and therefore lower treatment charges. Additionally, the escalators were reduced by the higher base zinc price used in the calculation of treatment charges in 2007 compared with Higher treatment and marketing costs as a percentage of gross sales revenue at Toqui in 2007 were due to increases in freight costs while at Mochito the lower percentage was due to certain concentrate sales which had flat treatment charges with no escalators. Treatment and Marketing Costs Gross sale Cost per Gross sale Cost per Aggregate revenue tonne sold Aggregate revenue tonne sold ($ millions) (%) ($) ($ millions) (%) ($) Mochito % % 425 Toqui % % 552 Myra Falls % % 512 Langlois (1) % 263 n.a. n.a. n.a. Total % % 488 (1) First concentrate shipped November 2006 and commenced commercial production on July 1, Direct Operating Costs Direct operating costs were 20% higher in 2007 at $161.6 million compared with $134.6 million in 2006, as 7% fewer tonnes of concentrate were sold and the average cost per tonne of concentrate sold increased to $662 in 2007 from $514 in The increase in the average direct operating cost per tonne sold was primarily due to similar aggregate costs at Myra Falls and Mochito despite 31% and 22% fewer tonnes sold respectively, higher costs at Toqui on greater sales and the impact of Langlois sales. Also see details of direct operating costs under each mine s Expenses in the Production Results section of this MD&A. Direct Operating Costs Gross sale Cost per Gross sale Cost per Aggregate revenue tonne sold Aggregate revenue tonne sold ($ millions) (%) ($) ($ millions) (%) ($) Mochito % % 333 Toqui % % 345 Myra Falls % 1, % 751 Langlois (1) % 830 n.a. n.a. n.a. Total % % 514 (1) First concentrate shipped November 2006 and commenced commercial production on July 1, Depreciation and Depletion Depreciation and depletion increased $5.2 million in 2007 compared with Langlois, which commenced commercial production effective July 1, 2007, was primarily responsible for the increase with depreciation and depletion of $5.0 million in FINANCIAL REPORT BREAKWATER RESOURCES LTD. 7

10 Reclamation and Closure Reclamation and closure costs increased by $3.3 million in 2007 compared with The increase was due to a $3.2 million provision for completion of modifications of the tailings facility at Myra Falls taken in the fourth quarter of General and Administrative General and administrative expenses increased by $1.6 million in 2007 compared with The increase was primarily due to: increased salaries and severance; higher corporate development consulting fees; higher travel and accommodation costs; the impact of a 2006 under accrual of bonuses; and, higher insurance costs partially offset by lower audit and internal control consulting fees and a refund of a deposit to purchase shares of Jascan Resources Inc. ( Jascan ) in Interest and Financing For 2007, interest and financing costs increased modestly as the $1.0 million fee to establish the qualifying environmental trust at Myra Falls in 2007 was partially offset by interest costs related to loans which were repaid in the first half of Investment and Other Income For 2007, investment and other income was $5.0 million lower than 2006 at $3.1 million. The decrease was primarily due to $7.6 million of unrealized loss on the valuation of conversion rights in certain convertible debentures held by the Company, which are considered embedded derivatives, primarily due to lower share prices and the marking to market of available-for-trade securities. Any unrealized gains or losses on the embedded derivatives are recorded through earnings. Foreign Exchange and Other For 2007, foreign exchange and other was $7.8 million higher at $9.8 million. The increased foreign exchange loss was primarily due to the impact of the strengthening C$ on US$ cash and cash equivalents. Exploration In 2007, exploration expenses increased 71% to $17.0 million compared with 2006 primarily due to increases at Langlois, Myra Falls, Mochito and the Company s joint venture properties partially offset by reduced expenses at Bouchard-Hébert and Toqui. Please refer to the exploration section of each mine and the project sections for details of the exploration activities in Refer to Note 1 of the Company s 2007 audited consolidated financial statements for the accounting treatment of exploration expenditures. Exploration ($ millions) Mochito Toqui Myra Falls Langlois 4.3 Non-operating Corporate 3.0 Total Write-down of Mineral Properties and Fixed Assets At December 31, 2007, the carrying value of the mineral properties and fixed assets at Myra Falls were written-down by $16.0 million as the net book value exceeded the fair value. Fair value was determined by using estimated future cash flow which included; estimated recoverable reserves; future metal prices and foreign exchange rates; and, estimated operating and capital costs. The write-down of $16.0 million was allocated against the fixed assets of Myra Falls on a prorata basis, based on the net book value before the write-down. Other Non-Producing Property Costs (Income) In 2006, the Company recorded a gain on sale of its Caribou property of $13.8 million and a charge of $1.3 million to settle a claim against the Company. Both these amounts were included in other non-producing property costs in Excluding the above amounts, other non-producing property costs were similar in 2007 and BREAKWATER RESOURCES LTD FINANCIAL REPORT

11 Income and Mining Tax Provision (Recovery) The income and mining tax provision increased to $26.6 million from a recovery of $1.3 million in 2006, a $27.9 million change. The increase was primarily due to a $27.0 million future tax asset for Myra Falls which was set-up in 2006, a $19.0 million write-down of the Myra Falls future tax asset in 2007 related to an impairment review and recognition of $5.2 million of Québec mining duties in 2006 partially offset by a $15.5 million future tax asset for Langlois established in 2007, a renunciation of the tax benefit of flow-through shares in 2006 of $2.3 million and $1.9 million of tax recoveries related to other comprehensive losses. LIQUIDITY AND FINANCIAL POSITION REVIEW Working Capital Working capital at the end of 2007 was $82.6 million compared with $109.9 million at the end of 2006, a decrease of $27.3 million. Current Assets Total current assets decreased by $3.9 million to $193.6 million at December 31, 2007 compared with December 31, The main components of current asset changes were: Cash and cash equivalents decreased by $18.5 million reflecting lower cash flow from operating activities and higher expenditures on mineral properties and fixed assets Accounts receivable concentrate decreased by $9.1 million primarily due to the timing of revenue recognition and lower metal prices reducing receivables at Myra Falls and Toqui Other accounts receivable increased by $4.3 million primarily due to sales tax receivables at Langlois and accrued interest income at Myra Falls Concentrate inventory increased by $21.1 million primarily due to the tonnes of concentrate in inventory increasing by 22,954 tonnes to 84,544 tonnes at December 31, Of the increased tonnes, 15,524 tonnes related to Langlois Materials and supplies inventory increased by $6.2 million primarily due to increased material in transit and higher costs and quantities of inventory at Mochito together with inventory at Langlois related to the commencement of commercial production Prepaid expenses and other current assets increased by $3.5 million primarily due to a $3.4 million deferral of stripping costs at Myra Falls related to the Lynx pit The current portion of future tax assets decreased by $13.3 million primarily due to a write-down in the current portion of the Myra Falls future tax asset of $12.5 million in the fourth quarter of 2007 Current Liabilities Current liabilities increased by $23.4 million to $111.0 million at December 31, 2007 compared with December 31, The main components of the current liabilities changes were: Provisional payments for concentrate inventory shipped and not priced, which represent payments received for concentrate shipments that were not recognized as revenue, increased by $8.0 million. The balance at December 31, 2007 was $32.2 million compared with $24.2 million at December 31, Refer to the table in Gross Sales Revenue section of this MD&A for additional details. Accounts payable and accrued liabilities increased by $18.9 million primarily due to a $5.9 million build-up at Langlois related to the commencement of commercial production, $6.1 million of provisional payments returnable to customers related to a fall in metal prices from the time the initial provisional payment was received to December 31, 2007, a $3.6 million increase in accounts payable and accrued liabilities at Myra Falls due to contractors employed on various capital and development projects and $2.2 million at Mochito primarily related to equipment and supplies in transit FINANCIAL REPORT BREAKWATER RESOURCES LTD. 9

12 Long-term Investments At December 31, 2007, long-term investments were $32.9 million, up $18.2 million from $14.7 million at December 31, The increase was primarily due to new accounting requirements for financial instruments and comprehensive income required by the Canadian Institute of Chartered Accountants ( CICA ) and adopted by the Company on January 1, Please refer to note 2 of the Company s 2007 audited consolidated financial statements. Reclamation Deposits At December 31, 2007, the Company had reclamation deposits of $33.5 million, an increase of $20.0 million from December 31, The increase was due to a $20.0 million qualifying environmental trust established in December 2007 for Myra Falls. The $13.5 million and $20.0 million of reclamation deposits are held under a safe keeping agreement and a trust indenture respectively to fund future reclamation requirements at Myra Falls. Restricted Promissory Note The Company held two restricted promissory notes at December 31, 2007 and December 31, 2006 of $62.3 million related to the Red Mile transactions 1 in 2004 and The interest earned and a portion of the principal of these restricted promissory notes will be used to meet the Company s royalty obligations. Deferred Income Deferred income of $5.7 million at December 31, 2007 consisted of: (i) deferred indemnity agreement fees and prepaid interest income received in relation to the Red Mile transactions in 2004 and 2005 which will be taken into income over the lives of the two agreements (see note 11 to the Company s 2007 audited consolidated financial statements); and, (ii) a non-refundable royalty payment received on the sale of the Lapa properties in 2003 (US$1.0 million) which will be taken into revenue as earned when the Lapa properties are put into production. Royalty Obligations The royalty obligations of $82.5 million relate to the royalty amounts received from the 2004 and 2005 Red Mile transactions and $20.0 million related to the qualifying environmental trust. See restricted promissory note and reclamation deposits above. Reclamation and Closure Cost Accrual Reclamation and closure costs represent the Company s obligation for reclamation and severance costs accrued for its mine sites. At December 31, 2007, total accrued reclamation and closure costs were $39.7 million compared with $40.6 million at December 31, During 2007, a provision for modifications to the tailings facility at Myra Falls was increased by $3.2 million for additional costs estimated to complete the modifications and was included in reclamation and closure costs. Of the $39.7 million, $6.5 million is classified as current and is expected to be spent over the next 12 months at Nanisivik, Bouchard-Hébert, Bougrine and Myra Falls. The Company incurred expenditures of $6.8 million in reclamation and closure costs in 2007 compared with $7.4 million in As there is currently no law, regulation or contract in Honduras related to reclamation and closure costs, GAAP does not permit the Company to set up a liability for reclamation at the El Mochito mine. Reclamation and Closure Cost Accrual at December 31, 2007 ($ millions) Current Long-term Total Myra Falls Mochito (1) Toqui Langlois Bouchard-Hébert Nanisivik Bougrine Total (1) Reclamation and closure cost accruals for Mochito relate to accrued severances. 1 For further information on the Red Mile transactions please see the Company s most recent Annual Information Form filed on SEDAR or available at the Company s website at 10 BREAKWATER RESOURCES LTD FINANCIAL REPORT

13 Shareholders Equity Shareholders equity at December 31, 2007 was $364.4 million compared with $308.6 million at December 31, The increase of $55.8 million was primarily due to net earnings of $23.4 million, the issuance of $12.0 million of flow-through shares, the exercise of $6.2 million of warrants and the impact of adopting new accounting policies as required by the CICA of $17.7 million. Other Cumulative Total Shareholders Equity Capital Contributed Retained comprehensive translation shareholders ($000 s) stock Warrants surplus earnings income adjustments equity As at December 31, ,093 8, ,795 (7,689) 308,553 Adjustment of opening balance on adoption of CICA accounting policy 5,706 4,291 7,689 17,686 Value ascribed to options exercised under stock based compensation 1,124 (1,124) Flow through share sale 11,988 11,988 Employee share option plan proceeds of options exercised 2,114 2,114 Employee share purchase plan Exercise of warrants and transfer of fair value 6,265 (21) 6,244 Stock-based compensation 2,149 2,149 Cancellation of shares (211) 211 Other comprehensive loss (8,108) (8,108) Net earnings 23,407 23,407 As at December 31, ,726 8,540 2, ,908 (3,817) 364,368 In 2007, the Company issued the following Common Shares: 3,002,289 following the exercise of employee share options; 165,453 pursuant to the Company s employee share purchase plan; 30,884,510 pursuant to warrants exercised; and, 6,122,449 for flow-through of exploration expenses on properties. Additionally, in 2007 the Company cancelled 120,747 unclaimed Common Shares related to the acquisition of Jascan in Capital Expenditures The Company invested $113.8 million in mineral properties and fixed assets in At mining operations, $23.1 million, $26.7 million, $21.4 million and $35.1 million were spent at Mochito, Toqui, Myra Falls and Langlois respectively. For details of these expenditures, please refer to the financial results discussion for each mine. Corporate capital expenditures of $7.5 million were primarily related to earn-in payments made on certain joint venture properties including Coulon in Québec. Financial Capability With the existing working capital, the current metal prices and current US$/C$ exchange rate, the Company expects to be able to carry out its operating, capital, exploration and environmental programs in The Company s financial capability is sensitive to metal prices, smelter treatment charges and the US$/C$ exchange rate. PRODUCTION RESULTS The table below contains the Company s production for the periods presented. Production results include the production from Langlois since January For accounting purposes, production from Langlois was not recognized on the income statement until the commencement of commercial production July 1, FINANCIAL REPORT BREAKWATER RESOURCES LTD. 11

14 Ore Milled (tonnes) 2,294,000 2,003,862 Zinc (%) Concentrate Production (tonnes) Zinc: Mochito 56,205 72,413 Toqui 65,322 63,617 Myra Falls 56,978 64,902 Langlois (1) 54,184 8, , ,133 Copper: Myra Falls 27,181 20,788 Langlois (1) 6,492 1,078 33,673 21,866 Lead: Mochito 15,470 17,263 Gold: Toqui 6,251 4,237 Myra Falls 14 6,251 4,251 C$ operating costs, production basis ($000s) 178, ,922 C$ operating cost per tonne milled (production basis) (1) First concentrate shipped November 2006 and considered to be at commercial production levels effective July 1, The table below contains the Company s metal contained in concentrate, before smelting deductions, for periods presented. Metal in Concentrate % Zinc (tonnes) Mochito 29,211 37,646 (22.4%) Toqui 32,191 31, % Myra Falls 29,845 33,708 (11.5%) Langlois (1) 28,327 4, % 119, , % Copper (tonnes) Myra Falls 6,086 4, % Langlois (1) 1, % 7,401 5, % Lead (tonnes) Mochito 10,215 11,775 (13.2%) Gold (ounces) Toqui 37,021 36, % Myra Falls 18,880 20,231 (6.7%) 55,901 57,026 (2.0%) Silver (ounces) Mochito 1,732,755 1,769,456 (2.1%) Toqui 155,890 71, % Myra Falls 811, ,775 (5.4%) Langlois (1) 159,672 22, % 2,859,670 2,721, % (1) First concentrate shipped November 2006 and considered to be at commercial production levels effective July 1, BREAKWATER RESOURCES LTD FINANCIAL REPORT

15 Aggregate production of zinc in concentrate in 2007 was 11.6% higher at 119,574 tonnes. The increased zinc was primarily due to production from Langlois partially offset by lower production at Mochito and Myra Falls. Production of copper in concentrate increased 45.3% in 2007 from 2006 due to Langlois, which commenced production in the fourth quarter of 2006 and increased production from Myra Falls. Production of lead in concentrate decreased 13.2% in 2007 due to a decrease in production at Mochito. Gold in concentrate decreased 2.0% year over year due to lower grades at Myra Falls partially offset by more tonnes milled and higher gold grades at Toqui. Silver in concentrate increased 5.1% year over year primarily due to higher silver grades at Toqui and a full year of production at Langlois. Mochito (I) MOCHITO FINANCIAL RESULTS Gross sales revenue 130, ,051 Treatment and marketing costs (23,252) (40,477) Net revenue 106, ,574 Direct operating costs (32,540) (31,765) Depreciation and depletion (4,374) (5,639) Reclamation and closure costs (1,099) (770) Contribution from mining activities 68,740 78,400 Exploration (2,919) (1,235) 65,821 77,165 Income and mining tax provision (19,132) (20,365) Net earnings 46,689 56,800 Capital expenditures 23,130 9,603 Revenue: The following tables and discussion provide details of Mochito s gross sales revenue for the periods indicated: Concentrate Realized Gross sales Concentrate Realized Gross sales sold Payable price (1) revenue sold Payable price (1) revenue (tonnes) metal (1) (US$) ($000s) (tonnes) metal (1) (US$) ($000s) Zinc 58,426 25,307 3,079 77,920 78,962 34,789 3, ,742 Lead 16,054 10,162 2,507 25,481 16,310 10,501 1,300 13,651 Silver n.a. 1,395, ,550 n.a. 1,467, ,851 74,480 95,272 Gross sales revenue in US$ 121, ,244 Exchange rate Gross sales revenue in C$ 130, ,051 (1) Payable metal and realized prices for zinc and lead are per tonne and for silver is per ounce. Concentrate sales in 2007 were 22% lower than in 2006 primarily due to 26% less zinc sold. Lower payable metals were partially offset by higher lead (93%) and silver (16%) prices resulting in 12% lower gross sales revenue in US$ terms. A 6% increase in the exchange rate resulted in 17% lower gross sales revenue in C$ in Expenses: Treatment and marketing costs were lower than in 2006 both in aggregate terms and on a per tonne sold basis primarily due to lower zinc prices and, to a lesser extent, fewer tonnes of concentrate sold and the weakening of the US$ as noted in the table above and in the Treatment and Marketing Cost section of the Statement of Operations Review in this MD&A. Additionally, in 2007 Mochito sold some concentrate which had flat treatment charges and no escalators FINANCIAL REPORT BREAKWATER RESOURCES LTD. 13

16 Direct operating costs increased due to increased power consumption and fuel surcharges as well as due to a switch to an improved, more expensive method of ground control and support. Upgrades to the electrical system and other major initiatives and upgrades also added to direct operating costs. Reclamation and closure costs in 2007 increased from 2006 primarily due to increased accruals for severance payments in 2007 compared with Exploration expenses increased in 2007 compared with 2006 due to the expanded exploration program in Please refer to the exploration section below for additional details. The decrease in the income and mining tax provisions at Mochito for 2007 compared with 2006 were primarily due to lower earnings before tax. Capital Expenditures: At Mochito, $23.1 million was primarily spent as follows: $4.7 million for tailings facilities; $4.6 million for mobile equipment; $3.6 million for mine development; $5.4 million for the mill, buildings and services; $1.9 million for equipment; $1.9 million for deferred development; and, $0.9 million of capitalized exploration. (II) MOCHITO PRODUCTION Mochito s production is set out in the following table Ore Milled (tonnes) 607, ,243 Zinc (%) Lead (%) Silver (g/t) Concentrate Production Zinc (tonnes) 56,205 72,413 Recovery (%) Grade (%) Lead (tonnes) 15,470 17,263 Recovery (%) Grade (%) Metal in Concentrates Zinc (tonnes) 29,211 37,646 Lead (tonnes) 10,215 11,775 Silver (ounces) 1,732,755 1,769,456 US$ operating costs, production basis ($000s) 31,656 26,329 US$ operating cost per tonne milled (production basis) As planned, milled tonnage was lower during the fourth quarter of 2007 compared with the same period in 2006 and accordingly, less zinc and lead in concentrate was produced due to fewer tonnes milled as well as lower zinc and lead grades. The lower head grades were due to a shortage of backfill for the most productive stopes due to the temporary suspension of milling operations resulting in the mine having to rely on lower grade stopes to maintain production. Additionally, planned mining of a higher grade portion in the Barbasco area was delayed due to backfill and ground stability issues which occurred causing mining of the lower grade mantos in Nacional, La Leona and Salva Vida instead. Despite the temporary suspension of milling operations during the fourth quarter of 2007, as described below more fully, the Company reached forecasted throughput. Payable zinc production was lower than forecast while silver and lead were both higher. Mining activities were focused on developing new production areas as well as developing exploration headings. On October 18, 2007, the Company announced that it had discovered a discharge of water from the newly commissioned Soledad tailings impoundment area which necessitated a temporary suspension of milling at Mochito. It was determined that re-commissioning the Pozo Azul tailings impoundment area, for which permitting remained in place, would be the quickest method of returning Mochito to full production. Mining continued throughout this period and construction is underway at Pozo Azul to increase the capacity of this tailings impoundment area to hold up to 24 months of additional material while plans are being 14 BREAKWATER RESOURCES LTD FINANCIAL REPORT

17 formulated to repair Soledad. On December 6, 2007, the Company announced that milling operations had returned to normal levels and the Company is currently depositing tailings in the Pozo Azul tailings impoundment area. Earlier in 2007, a bank of flotation cells was added to the lead circuit for use when lead grades exceed 2.0%. These new flotation cells are being used exclusively while the existing cells undergo maintenance. The collective bargaining agreement at Mochito was renewed for three years effective October 1, (III) MOCHITO EXPLORATION The Company continued drilling to identify new mineral resources in several areas of the mine as well as validating the prospectivity of other areas with older drill information. Drilling commenced during the fourth quarter of 2007 in the Santo Niño manto area with the objective of upgrading resources and validating older drill information related to both reserves and resources. In the eastern area of the Mochito mine, the Deep North area was drilled during the fourth quarter of Drilling has encountered two areas of chimney-style mineralization as well as an area of manto-style mineralization. This campaign is expected to continue throughout Exploration drilling continues to confirm the existence of manto-style mineralization of economic interest north of the Salva Vida and San José areas as well as the areas between the Salva Vida, San José and Yojoa deposits. During the fourth quarter of 2007, exploration drilling at Nacional SW intercepted two zones with economic mineralization. One of these zones correlates with La Leona mineralization and the other one relates to the southern extension of manto-style mineralization in the Nacional area. Drilling at Yojoa manto has tested areas with older information that required validation of the data. Drilling in the area of the Santo Niño Chimney was postponed due to mine development requirements in the area. Drilling will be carried out during Surface exploration continues to test the Big Fuzzy target. During the fourth quarter of 2007, a total of 1,419 metres were drilled. Strong evidence of skarn alteration as well as mineralization was intercepted within Hole BF-06, which is a step-out hole towards the west. A 20 square kilometre soil geochemical survey centered on the main Mochito graben area was initiated during the fourth quarter with a total of 336 soil samples collected. The soil survey will be completed during the first quarter of (IV) MOCHITO OUTLOOK During 2008 Breakwater plans to conduct a total of 35,000 metres of exploration diamond drilling both on surface and underground. Several underground targets will be investigated that, if successful, could deliver significant new resources. A sound underground exploration program is in place to develop and validate new extensional targets. On surface, exploration drilling will continue to investigate the Big Fuzzy target where strong evidence of skarn alteration as well as mineralization has been encountered. During the second quarter, an aerial photo survey will be carried out in order to produce a topographic map which will greatly aid in exploration of the entire Mochito graben. Geological mapping will be carried out during the year with particular emphasis on surface structural mapping. Soil geochemical surveys will be continued with the objective of covering the entire Mochito land package. The above work will improve the geological and exploration database to generate district targets. Production levels will return to more normal levels during There is an extensive capital improvement plan in place for 2008 which includes equipment replacement and infrastructure upgrades. Orders have been placed for four new scooptrams, three underground haulage trucks, a drill jumbo, personnel carriers, a lube truck and a scissor lift. Programs are underway to increase pumping capacity, improve underground electrical power distribution and to improve the ventilation system. Construction work on increasing the capacity of the Pozo Azul tailings facility is on schedule and should provide ample capacity while repairs are made to the Soledad facility. Repairs to Soledad are scheduled to begin during the next dry season with completion anticipated late in The Company is investigating the placement of thickened tailings as an alternative to the present tailings disposal methodology. Should this prove feasible, then one further possibility is converting the underground backfill system to a paste backfill system FINANCIAL REPORT BREAKWATER RESOURCES LTD. 15

18 Toqui (I) TOQUI FINANCIAL RESULTS Gross sales revenue 114,785 99,776 Treatment and marketing costs (40,245) (30,277) Net revenue 74,540 69,499 Direct operating costs (28,262) (18,941) Depreciation and depletion (4,311) (2,812) Reclamation and closure costs (276) (298) Contribution from mining activities 41,691 47,448 Exploration (2,734) (4,145) 38,957 43,303 Income and mining tax provision (5,919) (1,781) Net earnings 33,038 41,522 Capital expenditures 26,738 8,363 Revenue: The following tables and discussion provide details of Toqui s gross sales revenue for the periods indicated: Concentrate Realized Gross sales Concentrate Realized Gross sales sold Payable price (1) revenue sold Payable price (1) revenue (tonnes) metal (1) (US$) ($000s) (tonnes) metal (1) (US$) ($000s) Zinc 67,825 27,642 3,143 86,879 51,926 21,236 3,485 74,007 Gold 4,313 28, ,831 2,703 23, ,900 Silver n.a. 5, n.a. 8, Lead n.a. n.a. n.a. n.a ,138 54,875 Gross sales revenue in US$ 106,788 88,009 Exchange rate Gross sales revenue in C$ 114,785 99,776 (1) Payable metal and realized prices for zinc and lead are per tonne and for gold and silver are per ounce. Concentrate sales increased by 31% in 2007 compared with 2006 primarily due to 31% and 60% increases in zinc and gold concentrate sales respectively. Increased payable metals and 19% higher realized prices for gold were partially offset by 10% lower realized zinc prices resulting in a 21% increase in gross sales revenue in US$ terms. A 5% increase in the exchange rate resulted in gross sales revenue increasing 15% in C$ terms in Expenses: In 2007, treatment and marketing costs in the aggregate and as a percentage of gross revenue were higher compared with 2006 primarily due to significantly more tonnes of concentrate sold, higher freight costs and lower zinc prices partially offset by lower treatment charge escalators and the effects of exchange rate changes. Direct operating costs increased primarily due to significantly higher concentrate sales in 2007 compared with Higher labour costs related to the union agreement settlement, wage inflation indexing and addition manpower for special projects also contributed to higher direct operating costs. Additionally, increases in the cost of consumables such as tires, mill grinding media, reagents and fuel as well as an unfavourable movement in exchange rates negatively impacted direct operating costs. Depreciation and depletion costs increased in 2007 primarily due to the higher concentrate sold and lower exchange rates compared with Exploration expenses decreased in 2007 due to expenditures related to Concordia and Porvenir. Expenditures associated with these deposits were capitalized in 2007 and expensed in Please refer to the exploration section below for additional details. 16 BREAKWATER RESOURCES LTD FINANCIAL REPORT

19 In 2007, the income and mining tax provision increased due to the remaining tax loss carry forwards from 2006 being utilized and the establishment of a future tax liability in Capital Expenditures: Toqui capital expenditures of $26.7 million consisted primarily of $14.0 million for development (including $9.2 million for Concordia and Porvenir), $3.3 million for mine equipment, $1.8 million for capitalized exploration, $4.1 million for mill equipment and modifications and $3.5 million for service and infrastructure upgrades. (II) TOQUI PRODUCTION Toqui s production is set out in the following table Ore Milled (tonnes) 522, ,803 Zinc (%) Gold (g/t) Concentrate Production Zinc (tonnes) 65,322 63,617 Recovery (%) Grade (%) Gold (tonnes) 6,251 4,237 Recovery (%) Grade (g/t) Metal in Concentrates Zinc (tonnes) 32,191 31,725 Gold (ounces) 37,021 36,795 Silver (ounces) 155,890 71,703 US$ operating costs, production basis ($000s) 24,171 20,325 US$ operating cost per tonne milled (production basis) Production of zinc in concentrate increased during the fourth quarter of 2007 compared with the same period in 2006 due to milling more tonnes and higher grades while gold production was lower due to lower grades and less recovery in the gold concentrates. During 2007, the mining plan was modified due to ground control issues at Aserradero. This change resulted in the mining of fewer tonnes from Aserradero and more tonnes from the higher zinc grade Concordia deposit. The ground issues at Aserradero have been resolved and production has returned to normal. Production continues in Concordia North and decline development is proceeding towards Concordia South. The Concordia deposits will be an integral part of production in Underground programs, of about $5.0 million for capital development and $4.0 million for underground mobile equipment replacements, are both on schedule. The new surface mine shop, a new administration office and a new supervisors accommodation were all nearly complete at the end of Higher capital expenditures than forecast were primarily due to acceleration of the development of Concordia and Porvenir and related mobile and lead flotation circuit equipment requirements, paste fill plant preliminary engineering and tailings dam closure work. A mining contractor continues to develop the accesses to Porvenir. By year end, a total of 320 metres of development had been completed. Development of Porvenir is expected to take 16 months with production to begin early in (III) TOQUI EXPLORATION A $10 million exploration budget for 2007 included drilling as a major component to test some high-priority regional targets outside of the defined deposits within a distinct NW-SE anomalous trend. Exploration during 2007 resulted in a net 49% increase in Toqui s measured and indicated resources. Included is a net 64% increase in the proven and probable reserves principally due to the addition of the Porvenir deposit, for which a production decision has been made. The additions to all resource categories are expected to extend the mine life well beyond 2020 at current mine output and support the recent decision to commence a pre-feasibility study for a 1.0 million tonne per annum mill. Toqui is constrained by the capacity of its mill which runs at 1,475 tonnes per day or approximately 540,000 tonnes per annum FINANCIAL REPORT BREAKWATER RESOURCES LTD. 17

20 To the end of the fourth quarter of 2007, Toqui had completed 58.8 kilometres of drilling in more than 190 holes which resulted in the discovery of new mineralized zones aligned along the known NW-SE anomalous trend that crosses through the Toqui district as well as confirming the shape and continuity of Porvenir and Concordia. During the fourth quarter of 2007, four diamond drills carried out 15.5 kilometres of extensional and exploration drilling at Toqui. Fifty-three holes were drilled on the north-west and south-east extensions of the Porvenir deposit, due south of Aserradero, and extensions towards the south-east of Concordia, located north-west of Estatuas. Exploration drilling also tested new areas south-east of Concordia and at Cerro Elefantes in the north-west of the Toqui property. At Porvenir, the Company has proven that mineralization is continuous along a NW-SE anomalous trend as well as down dip. Recent intercepts in holes PDT-91 and PDT-98 are confirming the occurrence of a gold skarn system towards the south-east of Porvenir that could be structurally related to the gold skarn system of Aserradero. PDT-91 intercepted 11.5 metres (core length) of economic grade gold skarn while PDT-98 (the most south-east intercept) intercepted 4.5 metres (core length) of economic grade gold skarn with almost no zinc values. These recent results indicate that the south-east extension of Porvenir is one of the most promising untested areas in the district. To the north-west of Porvenir, drilling continues with the goal of discovering the extensions of the Porvenir deposit as well as establishing a connection with the Estatuas deposit located 1.5 kilometres towards the north-west. The latest drill results from north-west of Porvenir indicate that there is a potential for a much larger mineralized system in this area. Hole PNW-03 intercepted 4.6 metres of economic grade zinc within a package of 26.5 metres of fossiliferous coquina. Following the alteration zonation model, it is expected that mineralization will continue towards the main Don Amado feeder located west of PNW-03. Exploration drilling has shown encouraging results in other areas of the district, including an area located 300 metres south-east of the Concordia deposit. A soil geochemical survey and geological mapping over the area have highlighted a multi-element response of underlying mineralization at the Concordia South-East area. The area of Concordia East has indications from exploration drilling that mineralization remains open down dip and in all directions aligned along certain specific structures that control mineralization. Additional exploration drilling has tested an area known as Cerro Elefantes which is one of the distinctive geophysical (low resistivity) anomalies in the north-western area of Toqui that also coincides with a soil geochemical anomaly. A three dimensional magnetic anomaly beneath Cerro Elefantes is part of a larger magnetic body that extends to the north-west. An interpretation of the magnetic data indicates that the conductor extends to the north-west and below cretaceous rocks. Strong pyrite-silica/chalcopyrite/molybdenite stockwork mineralization was encountered within a 1,000 metres thick vertical package of Jurassic volcanic rocks. Significant alteration and mineralization was detected that could be interpreted as being part of a large porphyry system. This result is encouraging and in the future the Company is planning to explore underneath the volcanic sequence with the aim of discovering a high grade copper skarn deposit hosted in the underlying Paleozoic marbles. Exploration diamond drilling is now under way on the Catedral Project, a 2.5 kilometre by 1.0 kilometre area that connects the Concordia deposit with the north and north-west sectors of the former producing Doña Rosa mine. Initial exploration drilling has returned encouraging results and this program will continue in The collective bargaining agreement at Toqui was renewed for three years effective October 1, Management s goal was to secure a three-year agreement to ensure that there is labour harmony during any construction period related to the possible construction of a new mill at El Toqui. (IV) TOQUI OUTLOOK The new lead flotation circuit expansion is expected to be operational in the first quarter of 2008 which is expected to improve lead concentrate production. New mine offices and mobile equipment shops were commissioned during the fourth quarter of 2007, while a new change house, general offices and a new warehouse will be operational during the first quarter of Engineering studies continue for the construction of a paste backfill plant as well as for a new tailings impoundment area, based on paste tails deposition. Other projects are in progress in an effort to ensure that the appropriate infrastructure is in place to allow efficient construction of a new mill, should the pre-feasibility study be positive. The engineering consultants retained for the study expect to deliver their final report by mid BREAKWATER RESOURCES LTD FINANCIAL REPORT

21 Myra Falls (I) MYRA FALLS FINANCIAL RESULTS Gross sales revenue 134, ,758 Treatment and marketing costs (31,347) (57,161) Net revenue 103, ,597 Direct operating costs (83,667) (83,866) Depreciation and depletion (8,839) (8,929) Reclamation and closure costs (4,840) (1,473) Contribution from mining activities 5,973 48,329 Foreign exchange and other (1,232) Exploration (3,328) (617) Write-down of mineral properties and fixed assets (16,000) (13,355) 46,480 Income and mining tax (provision) recovery (18,890) 26,202 Net earnings (loss) (32,245) 72,682 Capital expenditures 21,362 16,596 Revenue: The following tables and discussion provide details of Myra Falls gross sales revenue for the periods indicated: Concentrate Realized Gross sales Concentrate Realized Gross sales sold Payable price (1) revenue sold Payable price (1) revenue (tonnes) metal (1) (US$) ($000s) (tonnes) metal (1) (US$) ($000s) Zinc 50,243 21,890 3,156 69,085 86,458 37,872 3, ,615 Copper 26,523 5,654 6,928 39,171 25,120 5,442 7,217 39,275 Gold 3 15, , , ,074 Silver n.a. 663, ,967 n.a. 594, ,795 76, ,602 Gross sales revenue in US$ 128, ,759 Exchange rate Gross sales revenue in C$ 134, ,758 (1) Payable metal and realized prices for zinc and copper are per tonne and for gold and silver are per ounce. Concentrate sales in 2007 were 31% lower than in 2006 with 42% less zinc sold partially offset by 6% higher copper sales. Except for copper, all metal prices realized in 2007 were higher than those in 2006 but did not offset generally lower payable metal resulting in a 27% decrease in gross sales revenue in US$ terms. Additionally, an 8% reduction in the exchange rate resulted in 33% lower gross sales revenue in C$ terms. Expenses: Treatment and marketing costs in the aggregate, per tonne concentrate sold and as a percentage of gross revenue were all lower in 2007 compared with 2006 primarily due to significantly fewer tonnes of concentrate sold, lower zinc prices, lower escalators and exchange rate impacts noted above. Despite higher tonnages milled in 2007, aggregate direct operating costs were flat while concentrate sales were 31% lower than in 2006 resulting in a significant increase in costs per tonne sold. Lower concentrate sales were primarily due to lower grades for zinc, gold and silver in 2007 partially offset by higher copper grades. Lower production from underground due to delays accessing ore, weather related challenges and inefficiencies were partially offset by ore from the Lynx pit. Also see the tables in the Direct Operating Costs section of the Statement of Operating Results in this MD&A. Reclamation and closure costs in 2007 increased from 2006 primarily due to a $3.2 million expense in the fourth quarter of 2007 related to a revised estimate of the cost to complete upgrades to the existing tailings facility FINANCIAL REPORT BREAKWATER RESOURCES LTD. 19

22 Exploration expense increased in 2007 compared with 2006 due to an expanded exploration program in Please refer to the exploration section below for additional details. At December 31, 2007, the Company reviewed Myra Falls for impairment due to the losses generated in the third and fourth quarters of 2007 which were primarily due to high direct operating costs, lower metal prices and higher exploration expenses. A life of mine cash flow forecast was prepared based on: (i) the reserves at December 31, 2007 including conversion of certain resources into reserves; (ii) estimated capital expenditures for sustaining capital and to bring reserves into production; (iii) estimated future operating costs; and, (iv) anticipated metal prices, treatment and marketing costs, freight costs and US$/C$ exchange rates. A sensitivity analysis was performed on the forecast which indicated that the cash flows at Myra Falls are highly sensitive to zinc and copper prices, direct operating costs, zinc treatment costs, US$/C$ exchange rate and freight costs. Based on the review performed, the Company determined that Myra Falls was impaired as at December 31, The carrying value of the mineral properties and fixed assets at Myra Falls were written-down by $16.0 million as the net book value exceeded the fair value. The write-down of $16.0 million was allocated against the fixed assets of Myra Falls on a prorata basis, based on the net book value before the write-down. The increase in income and mining tax provision was due to a write-down of $19.0 million in 2007 and an increase in the future tax asset of $27.0 million in 2006 respectively. Capital Expenditures: Myra Falls capital expenditures of $21.4 million consisted primarily of $5.6 million and $2.6 million for development at Lynx 5/6 and Price respectively, $3.4 million of mobile equipment purchases, $2.9 million of deferred development, $2.0 million for ramp development, $2.1 million for a ventilation raise, $1.2 million for a new tailings disposal area and $1.4 million for building construction and mill equipment. (II) MYRA FALLS PRODUCTION The following table sets forth Myra Falls production for the periods presented Ore Milled (tonnes) 726, ,443 Zinc (%) Copper (%) Gold (g/t) Silver (g/t) Concentrate Production Zinc (tonnes) 56,978 64,902 Zinc Recovery (%) Zinc Grade (%) Gold Recovery (%) Gold Grade (g/t) Copper (tonnes) 27,181 20,788 Copper Recovery (%) Copper Grade (%) Gold Recovery (%) Gold Grade (g/t) Gold (tonnes) Recovery (%) Grade (g/t) 9,400 9,489 Metal in Concentrates Zinc (tonnes) 29,845 33,708 Copper (tonnes) 6,086 4,885 Gold (ounces) 18,880 20,231 Silver (ounces) 811, ,775 C$ operating costs, production basis ($000s) 91,736 74,001 C$ operating cost per tonne milled (production basis) BREAKWATER RESOURCES LTD FINANCIAL REPORT

23 Production of zinc in concentrate was 7.6% higher in the fourth quarter of 2007 compared with the same period in 2006 due to higher tonnes milled. Production was lower than anticipated due to the delayed commissioning of additional haulage trucks which were put into production near the end of the fourth quarter and delays in hoisting mined material due to longer tramming distances. Production of zinc in concentrate in 2007 was 11.4% lower than 2006 due to lower zinc head grades. (III) MYRA FALLS EXPLORATION The first diamond drill results began to emerge from the Marshall Zone during the fourth quarter of The first two holes confirmed the continuity of the sulphide-bearing structure, however the mineralization was weak. The third hole intersected good mineralization and also confirmed the continuity of the zone. Ongoing interpretive work together with the recent data indicates that the zone is opening up to the west, an untested area. A ramp is now being driven to the Lynx 12 Level. These old workings will open approximately two kilometres of the old mine to exploration including the most westerly extents of the mine. Targets that can be tested from the 12 Level include the Ridge West, the extension of the Lynx S, and perhaps even the western extension of the Marshall Zone. Approximately one half of the 80 metres of ramping had been completed by year end. The definition program continues to extend the Bornite, Gnu, and HW Upper zones. The definition drill program was delayed by the shift of many drillers to the Marshall program. (IV) MYRA FALLS OUTLOOK As noted above, at December 31, 2007, the carrying value of the mineral properties and fixed assets at Myra Falls were written-down by $16.0 million as the net book value exceeded the fair value. Fair value was determined by using estimated future cash flow as described previously. The Company has taken action to reduce the labour force and implement more rigorous controls over mine planning and operations in order to achieve the life of mine plan. Readers are cautioned that should the assumptions in the life of mine plan not be achieved, an additional write-down in the carrying value of Myra Falls may be required in the future. The Surface Ramp is now complete to the Lynx 15 level and development of the ramp to 18 level continues with breakthrough expected in the fourth quarter of The ramp provides sufficient volumes of fresh air to the western extremities of the Battle Gap mine to allow additional haulage equipment into the stoping areas and for development to the north and west. A new ventilation raise was driven from the Gopher zone up to the drift to bring additional ventilation into the Gopher and Main zones which are expected to be the main mining areas for the next two to three years. The mining of some of the higher grade open pit material, anticipated in the third and fourth quarters of 2007, was delayed due to pit wall instability which has been addressed and the copper zone from the open pit has now been mined with the zinc zone to be mined by the end of the first quarter of Development of Lynx 5 is in progress and mining will commence in the first half of Development of Price is ongoing with production expected in the second half of The construction of the new tailings facility is on schedule for completion in FINANCIAL REPORT BREAKWATER RESOURCES LTD. 21

24 Langlois (I) LANGLOIS FINANCIAL RESULTS Financial information: Gross sales revenue 24,879 Treatment and marketing costs (5,444) Net revenue 19,435 Direct operating costs (17,145) Depreciation and depletion (5,032) Reclamation and closure costs (101) (100) Contribution from mining activities (2,843) (100) Exploration (4,313) (7,156) (100) Income and mining tax recovery (provision) 15,470 (5,167) Net earnings (loss) 8,314 (5,267) Capital expenditure 35,105 39,535 Revenue: Langlois was considered to be in commercial production effective July 1, For accounting purposes, revenue from concentrate produced and sold after commencement of commercial production is included in the income statement. Net cash flow from concentrate produced prior to July 1, 2007 reduced preproduction capital expenditures when sold. The following tables and discussion provide details of Langlois gross sales revenue for 2007: Concentrate Realized Gross sales sold Payable price (1) revenue (tonnes) metal (1) (US$) ($000s) Zinc 17,817 7,822 2,589 20,251 Copper 2, ,023 2,221 Silver n.a. 62, Gold n.a ,663 Gross sales revenue in US$ 23,554 Exchange rate Gross sales revenue in C$ 24,879 (1) Payable metal and realized prices for zinc and copper are per tonne and for gold and silver are per ounce. Expenses: For the first six months of commercial production beginning July 1, 2007, treatment and marketing costs were $5.4 million or 22% of gross sales revenue and $263 per tonne of concentrate sold and direct operating costs were $17.1 million or 69% of gross sales revenue and $830 per tonne of concentrate sold. Depreciation and depletion was $5.0 million since July 1, The carrying value of Langlois is higher than the Company s other mines and therefore depreciation and depletion will tend to be higher. Prior to the commencement of commercial production, exploration expenditures were capitalized. In the last half of 2007, a significant exploration program continued at Langlois with $4.3 million of expenses incurred. Please refer to the exploration section below for additional details. Income and mining tax recovery increased $20.6 million to a recovery of $15.5 million in 2007 from a provision of $5.2 million in 2006 related to Québec mining duties. The increased recovery was principally due to a $13.4 million future tax asset set-up in BREAKWATER RESOURCES LTD FINANCIAL REPORT

25 Capital Expenditures: At Langlois, $35.1 million was spent consisting primarily of $29.5 million for development of Langlois (including $3.8 million of capitalized exploration), $12.6 million of underground development, preproduction and equipment for Grevet B and $10.2 million for equipment, buildings and mine infrastructure partially offset by $17.3 million contribution from mining operations during the preproduction period. (II) LANGLOIS PRODUCTION Langlois, which is situated in north-western Québec approximately 213 kilometres north of Val-d Or, reached commercial production as of July 1, Production commenced during the fourth quarter of 2006 in Zones 3 and 4 with a total of 437,875 tonnes milled during Development drifts continue to be driven between Zone 3, Zone 4 and Zone 97 to the east on levels 4, 9 and 13. Ramp development from level 9 to access Zone 97 between level 9 and level 4 continued during the fourth quarter of Development of a decline to access Zone 97 between level 9 and level 13 commenced during the third quarter and will continue during Development of the new surface ramp continued during the quarter with breakthrough to the upper portions of Zone 4 expected in the fourth quarter of Tonnes milled during the fourth quarter of 2007 were less than anticipated due to 10 days lost production resulting from a shaft incident and delays at the Grevet B deposit, located three kilometres south-east of Langlois, due to water inflows. The following table sets forth Langlois production for the periods presented Ore Milled (tonnes) 437,875 59,373 Zinc (%) Copper (%) Silver (g/t) Concentrate Production Zinc (tonnes) 54,184 8,201 Recovery (%) Grade (%) Copper (tonnes) 6,492 1,078 Recovery (%) Grade (%) Metal in Concentrates Zinc (tonnes) 28,327 4,057 Copper (tonnes) 1, Silver (ounces) 159,672 22,855 C$ operating costs, production basis ($000s) 26,725 n.a. C$ operating cost per tonne milled (production basis) 106 n.a. (III) LANGLOIS EXPLORATION The Company currently has four diamond drills operating on the property on surface, two for exploration of Zone 5, one focused on the lower portion of Zone 97 and one on Orphée. A 52.6 kilometre drill program was conducted during 2007 to investigate the highly prospective extensions of all the known zones containing resources and reserves at the mine. The program, started in 2007, will eventually cover an area two kilometres along the strike of the Langlois deposit to a depth of 800 metres below surface. One objective is to upgrade some of the known inferred resources into the indicated category. Very few of the proximal zone extensions have been tested from underground due to a lack of development. During the fourth quarter of 2007, 8.5 kilometres of drilling were completed with four drills by the mine geology department. Zones 1, 3, 4 and 97 near surface and underground extensions were drilled from both surface and underground FINANCIAL REPORT BREAKWATER RESOURCES LTD. 23

26 At Zone 3, economic mineralization appears to extend to surface and consequently a new resource estimate from surface to 130 metres below surface was prepared as reported on September 18, A subsequent infill drilling program was carried out in order to upgrade some inferred resources into the indicated category. Holes were drilled between levels 6 and 8 to decrease the spacing between holes and results to date confirm that the mineralization in this area of Zone 3 is economic. Zone 4 was also drilled from underground to delineate its western extension between levels 3 and 5. Economic mineralization was encountered extending the current resource limit of the zone at least 200 metres along strike and 50 metres vertically. Drilling continues and this sector will be included in the next resource estimation. Drilling on Zone 5 has successfully outlined a westerly dipping volcanogenic massive sulphide ( VMS ) lens. The Company is conducting a second phase of drilling that began during the fourth quarter of 2007 to build geological confidence and to bring Zone 5 to a resource evaluation basis which will lead to a pre-feasibility study during A bulk sampling permit for Zone 5 was issued in early Mining and milling this bulk sample should provide the metallurgical information necessary to prepare a mine plan for this deposit. It is anticipated that this bulk sample will be processed during the second quarter of (IV) LANGLOIS OUTLOOK Zone 97 was tested both from surface and from underground on level 13. The surface drilling encountered limited shallow mineralization near the east extension of Zone 97. The underground drilling located 200 metres west of the known portions of Zone 97, continued to encounter economic mineralization. During the fourth quarter of 2007, 2,700 metres were drilled from level 11 to below level 13 and the mineralization is still open at depth and to the east. Additionally, a total of 2,100 metres were drilled from surface during the fourth quarter of During 2007, reinterpretation and re-modeling of all of the zones was carried out taking into account forecast base metal prices, lower cut-off grades and incorporation of all diamond drill intersections and channel samples in order to redefine the economic envelope. By the end of the year, all interpretation was completed and work was started on a fully integrated 3D block model. During the first quarter of 2008, underground drilling is expected to test the west and east extension of Zone 4 between levels 3 and 6. As well, drilling is expected to test the newly identified Zone 97 west extension. This drilling will be carried out from level 13 as development headings allow. Zone 3 west extensions between level 6 and 8 will also be tested before the end of the first quarter of Additional drilling will be required to the west of this area in order to upgrade the inferred resources to a reserve category. Zone 97 surface and east extensions will be drilled from surface to target the exploration area in close proximity to surface. During the first quarter of 2007, Metco Resources Inc. ( Metco ) announced that a pre-feasibility study would be conducted in 2007 on the Orphée deposit (50% Breakwater, 50% Metco). Should the results of the pre-feasibility be positive, the Orphée deposit, located nine kilometres from the Langlois mill, could provide additional mill feed for Langlois, which currently has excess mill capacity. The Company conducted a delineation drilling program over the western part of the Orphée deposit, of which it owns 100% of the mining rights, in order to enhance the pre-feasibility study. A second delineation program, expected to run through to the second quarter of 2008, is being conducted over the western part of the Orphée. A third phase may be necessary pending completion of the Metco agreement. In January 2008, the Company reached an agreement to purchase 100% of Metco for 7,000,000 Common Shares of the Company. This agreement is subject to normal closing conditions including the approval of the regulatory authorities and Metco shareholders. The transaction is expected to close mid-2008 and will enable the Company to consolidate its land position in the Lebel-sur-Quévillion camp, gain entry into a large and prospective land package in the Matagami camp and also secure additional feed for the Langlois mill. Coulon Project During the fourth quarter of 2007, Virginia Mines Inc. ( Virginia ) continued drilling on the Coulon property, located in the James Bay region of Québec. As of November 14, 2007, the Company fulfilled all its payment obligations totalling $180,000 and $7.5 million in exploration expenditures and now owns 50% of the Coulon joint venture. The Coulon joint venture property consists of 3,250 claims covering more than 90 kilometres of the prospective Coulon volcanic belt. A third deep drilling rig was mobilized during 2007 to accelerate exploration work. In the fourth quarter of 2007, two deep rigs focussed on delineating additional resources within lenses 43, 44 and 9-25 and a heliborne survey was carried out to explore for new drill targets on a regional scale. 24 BREAKWATER RESOURCES LTD FINANCIAL REPORT

27 Drill results released by Virginia during 2007 indicated continuity of the Coulon mineralized system over more than 20 kilometres along strike with the discovery of a new showing. The Spirit showing consists of semi-massive to massive sulphide mineralization rich in chalcopyrite and sphalerite, with slighter quantities of galena, hosted by sillimanite gneisses representing metamorphosed felsic volcanics. The electromagnetic conductor can be traced over a lateral distance of 80 metres, in a general north-south direction, and in a thickness of four to seven metres. This conductor remains open laterally since it disappears at both ends under a thick overburden which is greater than the investigation depth of the electromagnetic survey. Three unexplained, airborne EM conductors lie in the vicinity of the Spirit showing. Lens 43 is now confirmed over a lateral distance of 340 metres and a vertical depth of 430 metres and it is still open at depth. Lens 44 and 9-25 have been intercepted at depths to 575 and 550 metres respectively and both are also open at depth. Zone 8 has also been confirmed over a lateral distance of 250 metres and a vertical depth of 410 metres and is still open at depth. Trieste Project On September 14, 2007, the Company signed an agreement with Virginia on the Trieste property, which is also located in the James Bay area of Québec. Under the terms of the agreement, the Company has the option to acquire a 50% interest in the property, in exchange for $1.0 million of exploration work before May 8, 2011 and payments totalling $50,000. Virginia will be the operator. The Trieste property is located within the La Grande Archean volcano-sedimentary belt and covers an assemblage of mafic to felsic volcanics, iron formations, and a synvolcanic intrusion. Many electromagnetic conductors remain unexplained and VMS type mineralized showings returned values of up to 2.6% zinc within the volcanic sequence. An arsenopyrite-rich boulder also returned 20 g/t gold. During 2007, Virginia conducted field reconnaissance over the entire property. Gayot Project On August 23, 2007, the Company signed an option agreement with Virginia on the Gayot property, which is also located in the James Bay area of Québec. Under the terms of the agreement, Breakwater has the option to earn a 50% interest in the property in exchange for $10.0 million in exploration work over a 9-year period and payments totalling $170,000 on or before the fourth anniversary of the agreement. Virginia will be the operator until the completion of a positive pre-feasibility study. This agreement is subject to a 1% NSR in favour of Billiton Resources Canada. The Lac Gayot property consists of 116 claims covering 4, hectares and 3 mining exploration permits covering a surface area of 15,437 hectares. The property entirely covers the Venus Archean greenstone belt which consists dominantly of ultramafic MgO-rich sills and flows. This ultramafic sequence is the host to twelve nickel-platinum-palladium mineralized zones distributed over a strike length of 25 kilometres. During the fourth quarter, Virginia conducted an airborne geophysical survey over the entire property. Kaminak Project On April 26th, 2007, Kaminak Gold Corporation ( Kaminak ) and the Company entered into a generative strategic alliance targeting primarily nickel-copper-platinum group element deposits over parts of eastern North America. Each company initially funded $50,000 for data compilation, targeting and field work during Kaminak will initially act as Project Operator. Upon ground acquisition, a joint venture was formed on each separate property. The Company is bearing 100% of the exploration costs in each joint venture block until the cumulative total amount expended for exploration across all joint venture blocks equals $1.0 million. Upon completion of such expenditure, the interests of the parties in each joint venture shall be Breakwater 51% and Kaminak 49%. Within thirty days after Kaminak and Breakwater agree that this $1.0 million expenditure threshold has been reached, Breakwater can elect to increase its joint venture interest to 60% by funding the next $2.0 million in cumulative exploration costs across all joint venture blocks. By September 2007, Kaminak and the Company had acquired through staking a number of nickel targets within the Grenville geological province of southern Québec. These targets were recognized by Kaminak s technical team as a result of in-house geological and geophysical data compilations. Historical government assessment files from one such prospect reports up to 1.69% nickel plus 3.07% copper in selected samples hosted within orthopyroxenite. A separate prospect is reported to contain up to 1.31% nickel plus 0.83% copper from grab samples in peridotite and pyroxenite. A Kaminak field team has completed an initial program consisting of geological mapping, ground truthing of historical data and prospecting. Subsequent plans include airborne geophysics over selected targets in FINANCIAL REPORT BREAKWATER RESOURCES LTD. 25

28 Gatineau Project On September 11, 2007, the Company signed a letter agreement with Midland Exploration Inc. ( Midland ) for the Gatineau zinc properties, which are currently held 100% by Midland. The properties are located approximately 200 kilometres northwest of the city of Montreal. The Company can acquire 50% of Midland s interest during a four-year period by making cash payments of $250,000 and exploration expenditures of $4.5 million. Midland will be the operator until the completion of a positive pre-feasibility study. Upon acquiring a 50% interest, the Company will have the option to acquire an additional 15% interest with the delivery of a bankable feasibility study, by making cash payment of $40,000 per year and by funding a minimum of $200,000 of exploration work each year until the delivery of the study within a four-year period. This large land position including 19 new properties covers 34,760 hectares distributed in the Gatineau area. The area is known to host many significant zinc occurrences and prospects in metamorphosed Middle-Proterozoic marbles of the Grenville Supergroup. The interest for this area is that the zinc occurrences share many similarities with significant zinc deposits, also hosted in Grenville metamorphosed limestones. The most prolific zinc deposits of this type are those of the Balmat-Edwards district in the United States located only 60 kilometres south of the Gatineau properties area. This active mining district, in production since 1915, is known to host a combined 43 million tonnes at near 10% zinc including other commodities. The exploration program performed in the fourth quarter of 2007 included detailed stream sediment and soil geochemical surveys, geological mapping and prospecting. Weedon Project On September 11, 2007, the Company signed a letter agreement with Midland for the Weedon property, which is currently held 100% by Midland. The property is located in the Eastern Townships area, about 120 kilometres south of Québec City. The Company can acquire 50% of Midland s interest during a three-year period by making cash payment of $200,000 and exploration expenditures of $3.0 million. Midland will be the operator until the completion of a positive pre-feasibility study. Upon acquiring a 50% interest, the Company will have the option to acquire an additional 15% interest with the delivery of a bankable feasibility study, by making cash payment of $40,000 per year and by funding a minimum of $200,000 of exploration work each year until the delivery of the study within a four-year period. The property consists of 242 claims totalling 132 km² and covers more than 30 kilometres of the Ascot-Weedon volcanosedimentary belt. The Ascot-Weedon belt hosts several mined out VMS deposits and shows many similarities with other prolific VMS mining camps, namely Bathurst in New Brunswick and Buchans in Newfoundland. Many Cu-Zn-Pb-Au-Ag showings are also known in the belt and a new surface showing was discovered in the fall This new un-drilled semi-massive sulphide lens was stripped and sampled and yielded grades reaching 2.23% copper, 23.7% zinc, 5.95% lead, 263 g/t silver, and 9.22 g/t gold. No previous work is reported directly on this showing. Historically, exploration work on the Weedon property largely dates back to the 1970s. A modern VTEM survey was performed during the fourth quarter of 2007 over the entire property. Other Properties The reclamation work is largely complete at Bouchard-Hébert and Bougrine with Nanisivik expected to be largely reclaimed by the end of The mill at Bougrine remains intact pending exploration results elsewhere throughout the Company s properties and dismantling of the mill at Bouchard-Hébert has commenced. 26 BREAKWATER RESOURCES LTD FINANCIAL REPORT

29 FOURTH QUARTER REVIEW The Company realized a loss of $38.3 million or $0.09 per share in the fourth quarter of 2007 compared with net earnings of $50.4 million or $0.13 per share in the fourth quarter of The main items affecting the movement to a loss were: $28.5 million write-down of Myra Falls, comprising a $16.0 million write-down relating to the value of the mineral properties and fixed assets and a $12.5 million write-down of future tax assets related to the impairment write-down following a review triggered by lower metal prices and higher operating costs $11.3 million of unrealized losses primarily due to the valuation of conversion rights in certain convertible debentures held by the Company primarily due to lower share prices and the marking to market of available-for-sale trade securities $3.2 million provision for tailings facility modification at Myra Falls $22.9 million (US$3.1 million) lower gross sales revenue despite 40% greater tonnes of concentrate sold largely due to 38% and 12% lower zinc and copper prices respectively and a 13% appreciation in the C$ in 2007 compared with 2006 Sales of concentrate in the fourth quarter of 2007 increased to 102,415 tonnes from 73,231 in the fourth quarter of 2006 primarily due to Langlois and greater sales at Myra Falls and Toqui $15.1 million lower treatment and marketing costs primarily due to lower prices realized, higher zinc base prices resulting in lower escalators and the impact of a weaker US$ $37.3 million higher direct operating costs primarily due to increased sales, higher costs at Myra Falls and the addition of sales from Langlois, currently a relatively high cost operation $3.3 million increase in exploration expenses $7.5 million reduction of income tax at Mochito At December 31, 2007, the Company estimated that inventories shipped but not recognized for revenue purposes had earnings before tax of $8.0 million on 51,100 tonnes of concentrate compared with earnings before tax of $29.4 million on 70,519 tonnes of concentrate at September 30, Concentrate produced in the fourth quarter of 2007 increased to 72,470 tonnes from 67,057 tonnes primarily due to Langlois, increased production at Myra Falls and Toqui offset by lower production at Mochito. Successfully renegotiated new three year contracts at Toqui and Mochito and overcame a breach at a newly commissioned tailings impoundment at Mochito to resume normal production. The Company entered into a $20.0 million qualifying environmental trust to fully fund estimated reclamation and closure obligations at Myra Falls and issued $12.0 million of flow-through shares to fund a portion of the 2008 exploration program. The Company also commenced a pre-feasibility study at Toqui to support a 1.0 million tonne per year mill and earned a 50% interest in the Coulon joint venture property FINANCIAL REPORT BREAKWATER RESOURCES LTD. 27

30 Fourth Quarter 2007 Mochito Toqui Myra Falls Langlois (1) Other Total Ore milled (tonnes) 151, , , ,683 n.a. 584,361 Zinc (%) 4.6% 7.3% 4.7% 6.8% n.a. 5.7% Concentrate produced (tonnes): Zinc 11,656 17,813 13,599 13,935 n.a. 57,003 Copper n.a. n.a. 7,825 2,060 n.a. 9,885 Lead 3,527 n.a. n.a. n.a. n.a. 3,527 Gold n.a. 2,055 n.a. n.a. n.a. 2,055 Total 15,183 19,868 21,424 15,995 n.a. 72,470 Concentrate sold (tonnes): Zinc 27,801 26,241 15,960 15,562 n.a. 85,564 Copper n.a. n.a. 11,300 2,407 n.a. 13,707 Lead 1,878 n.a. n.a. n.a. n.a. 1,878 Gold n.a. 1,266 n.a. n.a. n.a. 1,266 Total 29,679 27,507 27,260 17,969 n.a. 102,415 Gross sales revenue 37,820 34,395 42,123 21,117 n.a. 135,455 Treatment and marketing costs 9,891 10,588 7,868 4,674 n.a. 33,021 Net revenue 27,929 23,807 34,255 16,443 n.a. 102,434 Direct operating costs 13,590 10,292 34,689 15,368 n.a. 73,939 Depreciation and depletion 1,656 1,285 3,383 4, ,845 Reclamation and closure costs , ,260 15,599 11,640 41,707 19, ,044 Contribution (loss) from mining activities 12,330 12,167 (7,452) (3,401) (254) 13,390 General and administrative 4,272 Interest and financing 2,009 Investment and other 8,415 Foreign exchange and other (155) Exploration 6,161 Write-down of mineral properties and fixed assets 16,000 Other non-producing property costs ,403 Loss before income and mining tax provision (24,013) Income and mining tax provision 14,323 Loss (38,336) (1) First concentrate shipped November 2006 and commenced commercial production on July 1, BREAKWATER RESOURCES LTD FINANCIAL REPORT

31 Fourth Quarter 2006 Mochito Toqui Myra Falls Langlois (1) Other Total Ore milled (tonnes) 171, , ,188 59,373 n.a. 528,237 Zinc (%) 6.2% 6.6% 4.6% 8.3% n.a. 6.0% Concentrate produced (tonnes): Zinc 18,726 15,979 12,950 8,201 n.a. 55,856 Copper n.a. n.a. 3,569 1,078 n.a. 4,647 Lead 5,239 n.a. n.a. n.a. n.a. 5,239 Gold n.a. 1,315 n.a. n.a. n.a. 1,315 Total 23,965 17,294 16,519 9,279 n.a. 67,057 Concentrate sold (tonnes): Zinc 27,734 18,393 20,745 n.a. n.a. 66,872 Copper n.a. n.a. n.a. n.a. n.a. n.a. Lead 4,921 n.a. n.a. n.a. n.a. 4,921 Gold n.a. 1,438 n.a. n.a. n.a. 1,438 Total 32,655 19,831 20,745 n.a. n.a. 73,231 Gross sales revenue 67,956 44,498 46,398 n.a. (516) 158,336 Treatment and marketing costs 20,101 12,212 15,765 n.a. n.a. 48,078 Net revenue 47,855 32,286 30,633 n.a. (516) 110,258 Direct operating costs 11,205 7,636 17,847 n.a. (1) 36,687 Depreciation and depletion 1,824 1,358 2,952 n.a ,239 Reclamation and closure costs ,347 9,069 21, ,898 Contribution (loss) from mining activities 34,508 23,217 9,485 (25) (825) 66,360 General and administrative 3,628 Interest and financing 981 Investment and other income (2,926) Foreign exchange and other 1,590 Exploration 2,898 Other non-producing property costs 619 6,790 Earnings before income and mining tax provision 59,570 Income and mining tax provision 9,150 Net earnings 50,420 (1) First concentrate shipped November 2006 and commenced commercial production on July 1, For a more detailed discussion of the Company s fourth quarter results, please refer to the Company s press release of the results of operations for the three and twelve months ending December 31, 2007 dated February 28, NON-GAAP RECONCILIATIONS Operating cost per tonne milled on a production basis is a performance indicator. It is a non-gaap measure and because there is no standard method for calculating it, operating costs per tonne milled on a production basis is not a reliable way to compare the Company against other companies. It can however allow an understanding of how production costs have changed from year to year and the impact on cash flows FINANCIAL REPORT BREAKWATER RESOURCES LTD. 29

32 Year ended December 31, 2007 ($000s) Mochito Toqui Myra Falls Langlois (1) Total Direct operating costs per financial statements 32,540 28,262 83,667 17, ,614 Adjustment to production basis 1,631 (33) 8,689 9,633 19,920 Less: stock-based compensation (186) (313) (620) (53) (1,172) Less: royalties n.a. (1,965) n.a. n.a. (1,965) Operating costs on a production basis 33,985 25,951 91,736 26, ,397 Average exchange rate Operating costs on production basis (US$) 31,655 24,172 85,447 24, ,167 Tonnes milled 607, , , ,875 2,294,000 Less: preproduction tonnes n.a. n.a. n.a. (186,517) (186,517) Tonnes milled, production basis 607, , , ,358 2,107,483 Operating cost per tonne milled US$ $52 $46 $118 $99 $79 Operating cost per tonne milled C$ $56 $50 $126 $106 $85 (1) First concentrate shipped November 2006 and commenced commercial production on July 1, Year ended December 31, 2006 ($000s) Mochito Toqui Myra Falls Langlois (1) Total Direct operating costs per financial statements 31,765 18,941 83,866 n.a. 134,572 Adjustment to production basis (1,711) 7,129 (9,359) n.a. (3,941) Less: stock-based compensation (189) (169) (506) n.a. (864) Less: royalties n.a. (2,845) n.a. n.a. (2,845) Operating costs on production basis 29,865 23,056 74,001 n.a. 126,922 Average exchange rate n.a Operating costs on a production basis (US$) 26,329 20,325 65,239 n.a. 111,893 Tonnes milled 690, , ,443 59,373 2,003,862 Less: preproduction tonnes n.a. n.a. n.a. (59,373) (59,373) Tonnes milled, production basis 690, , ,443 n.a. 1,944,489 Operating cost per tonne milled US$ $38 $38 $91 n.a. $58 Operating cost per tonne milled C$ $43 $43 $104 n.a. $65 (1) First concentrate shipped November 2006 and commenced commercial production on July 1, BREAKWATER RESOURCES LTD FINANCIAL REPORT

33 SUMMARY OF QUARTERLY RESULTS Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Gross sales revenue ($ millions) Net earning (loss) ($ millions) (38.3) Basic earnings (loss) per share $0.10 $0.08 $0.10 $0.13 $0.04 $0.09 $0.02 $(0.09) Weighted-average number of Common Shares outstanding (millions) Diluted earnings (loss) per share $0.09 $0.07 $0.09 $0.12 $0.04 $0.09 $0.02 $(0.09) C$/US$ realized exchange rate Average realized zinc price (US$/t) 2,221 2,895 3,363 4,227 3,434 3,710 3,200 2,608 Average realized zinc price (C$/t) 2,567 3,226 3,762 4,828 4,012 4,049 3,320 2,605 Concentrate tonnes sold (1) 67,355 59,779 61,385 73,231 39,333 51,553 50, ,415 Concentrate tonnes produced (1) 66,129 59,906 59,420 67,057 66,895 75,596 73,122 72,470 (1) Langlois commenced commercial production effective July 1, Included in concentrate produced in Q4 2006, Q and Q were 4,255, 9,571 and 14,921 tonnes respectively which are not included in concentrate tonnes sold. The quantity and mix of concentrates sold directly affects gross sales revenue. The recognition of revenue from the sale of concentrate can vary from quarter to quarter for the reasons discussed in the Gross Sales Revenue section of this MD&A. As all sales are based in US$, the US$ s general weakening against the C$ over the past eight quarters has reduced the realized C$ gross sales revenue. CONTRACTUAL OBLIGATIONS Contractual Obligations ($ millions) Payments Due by Period < 1 year >1-3 years 4-5 years > 5 years Total Capital leases Operating leases Debt Employee future benefits (1) Reclamation (1) Royalty obligations (1) 20.0 (2) Total (1) Employee future benefits, reclamation and royalty obligations have funding sources from pension plan assets ($34.8 million), reclamation deposits ($33.5 million) and restricted promissory notes ($62.3 million) respectively. See the Company s 2007 audited consolidated financial statements for additional details. (2) Breakwater has the right to purchase the interests of the limited and general partners for approximately $18.2 million (90.9% of the contribution to the QET) payable at the option of Breakwater in cash or Common Shares at the current market price. The right is exercisable from January 16, 2008 to April 15, TRANSACTION WITH RELATED PARTIES On March 2, 2007 and March 14, 2007, Dundee Corporation ( Dundee ) exercised 15,400,705 and 15,400,705 warrants respectively to purchase 30,801,410 Common Shares at $0.20 per Common Share. In December 2007, the Company issued 6,122,449 flow-through Common Shares by way of private placement at a price of $1.96 per Common Share exclusive of share issuance costs of $12,000 to a wholly-owned subsidiary of Dundee. The flow-through Common Shares have a four-month hold period. The proceeds of the flow-through shares will be used to finance exploration activities principally in Québec. Additionally, in 2007 an affiliated company of Dundee provided consulting services of $50,000. Dundee is a significant shareholder of the Company FINANCIAL REPORT BREAKWATER RESOURCES LTD. 31

34 CRITICAL ACCOUNTING ESTIMATES Asset Impairment The carrying values of producing mineral properties, including properties placed on a care and maintenance basis and related deferred expenditures, are reviewed when events or changes in circumstances arise that may result in impairments in the carrying value of those assets. Estimated future net cash flows, on an undiscounted basis, are calculated for each property using: estimated recoverable reserves; estimated future metal price realization (considering historical and current prices, price trends and related factors); and estimated operating, capital and other cash flow. Estimates of future cash flows are subject to risks and uncertainties. It is possible that changes could occur which may affect the recoverability of the carrying value of mineral properties. At December 31, 2007, the carrying value of the mineral properties and fixed assets at Myra Falls were written-down by $16.0 million as the net book value exceeded the fair value. Fair value was determined by using estimated future cash flow which included; estimated recoverable reserves; future metal prices and foreign exchange rates; and, estimated operating and capital costs. The write-down of $16.0 million was allocated against the fixed assets of Myra Falls on a prorata basis, based on the net book value before the write-down. The Company has taken action to reduce the labour force and implement more rigorous controls over mine planning and operations in order to achieve the life of mine plan. Readers are cautioned that should the assumptions in the life of mine plan not be achieved, an additional write-down in the carrying value of Myra Falls may be required in the future. Reserves Every year the Company estimates its proven and probable mineral reserves (the Reserves ) in accordance with National Instrument ( NI ), a rule adopted by Canadian securities administrators as the standard of disclosure for mineral projects. This estimate is used to determine mine viability, mine life and amortization rates. The estimation of Reserves is based on drill hole information, historical mining results, historical metallurgical results, estimated future operating costs and estimated future metal prices. A Qualified Person, as defined by NI , performs the Reserves estimate. As all of the Company s operations have had an operating history, the factor that could have the greatest impact on the Reserves estimate is future metal prices. Amortization The Company uses the units-of-production method for amortization of mineral properties and some of its fixed assets based on the Reserves. Any significant changes in the Reserves could impact the amount of annual amortization. Inventory The Company values its concentrate inventories at the lower of cost or realizable value at the end of the reporting period. Costs represent the average cost, and include direct labour and materials costs, mine site overhead and depreciation and depletion. Realizable value includes metal prices, net of treatment charges and freight. Metal prices can be subject to significant change from period to period. At December 31, 2007, all concentrate inventories were recorded at cost except for Myra Falls and Langlois which were recorded at realizable value. Future Tax Assets and Liabilities Future tax assets and liabilities are calculated using the asset and liability method. Under the asset and liability method, future tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Future tax assets and liabilities are measured using current tax rates. The effect on future tax assets and liabilities of a change in tax rates is recognized in income in the period the change is known. To the extent that the Company considers it to be more likely than not that a future tax asset will be recovered, a tax asset will be set up, otherwise the Company provides a valuation allowance against the excess. It is possible that changes could occur in the future that may affect the recoverability of the carrying value of future tax assets and a write-down may be required. Reclamation The Company provides for the fair value of liabilities and capitalized costs for asset retirement obligations in the period in which they are incurred. Over time, the liability is accreted to its present value and the capitalized cost is amortized over the useful life of the related asset. Asset retirement obligations are obligations of the Company that arise as a result of an existing law, regulation or contract related to asset retirements. Estimates of the liability associated with the retirement of an asset are based on current laws and regulations and the expected resulting costs, all of which are subject to change. If actual costs of reclamation exceed the recorded amount the Company will record a loss. Alternatively, if reclamation costs incurred are less than those recorded, the 32 BREAKWATER RESOURCES LTD FINANCIAL REPORT

35 Company will record a gain. Currently the Company is not able to set up a liability for reclamation at Mochito as there is no law, regulation or contract related to this asset s retirement. RISKS, UNCERTAINTIES AND OTHER INFORMATION Readers are encouraged to read and consider the risk factors, and additional information regarding the Company, included in its most recent Annual Information Report filed with the Canadian securities regulators, a copy of which is posted on the SEDAR website at OUTSTANDING SHARE DATA AND FULL DILUTION CALCULATION The Company is authorized to issue an unlimited number of Common Shares and 200,000,000 preferred shares, issueable in series. There are no preferred shares outstanding. Each Common Share entitles the holder of record thereof to one vote at all meetings of shareholders of the Company, except at meetings at which only holders of another class or series of shares of the Company are entitled to vote. The table set forth below summarizes the Capital Stock. For a more complete description of certain elements please refer to note 14 to the 2007 audited consolidated financial statements of the Company. Common Shares or Securities Convertible into Common Shares February 29, 2008 Issued and outstanding 425,775,355 Share options outstanding weighted-average exercise price $1.30 8,117,809 Warrants granted at $1.00, expire January 28, 2009 traded on TSX 33,488,329 Future fully diluted 467,381,493 CONCLUSION RELATING TO DISCLOSURE CONTROLS AND PROCEDURES An evaluation was performed under the supervision of and with the participation of management, including the President and Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the Company s disclosure controls and procedures as defined in the Multilateral Instrument Based on that evaluation, the President and Chief Executive Officer and the Chief Financial Officer concluded that the design and operation of the Company s disclosure controls and procedures were effective as at December 31, CAUTION ON FORWARD-LOOKING INFORMATION This report contains certain statements which constitute forward-looking information. These forward-looking statements are not descriptive of historical matters and may refer to management s expectations or plans. These statements include but are not limited to statements concerning the Company s business objectives and plans; future trends in the Company s industry; future production costs and volumes; mineral grades, reserve and resource estimates and types; sales volumes and realized prices; capital spending plans; exploration plans; expansion plans; expected market fundamentals and prices; availability of equipment and supplies; expected plant availability; success of process changes; the Company s processing technologies; global economic growth and industrial demand; production of base metal concentrates by the Company s operations; future metal prices and treatment charges; future royalties payable; changes in global metal and concentrate inventories; currency exchange rates; costs of energy, materials and supplies; the outcome of disputes and legal proceedings in which the Company is involved; future effective tax rates; and future benefits costs. Inherent in forward-looking statements are risks and uncertainties beyond the Company s ability to predict or control, including risks that may affect the Company s operating or capital plans, including risks generally encountered in the development and operation of mineral properties and processing facilities such as unusual or unexpected geological formations, unanticipated metallurgical difficulties, ground control problems, process upsets and equipment malfunctions; risks associated with labour disturbances and unavailability of skilled labour; fluctuations in the market prices of the Company s principal products, which are cyclical and subject to substantial price fluctuations; risks created through competition for mining properties; risks associated with lack of access to markets; risks associated with mineral and resource estimates, including the risk of errors in assumptions or methodologies; risks posed by fluctuations in exchange rates and interest rates, as well as general economic conditions; risks associated with environmental compliance and permitting, including those created by changes in environmental legislation and regulation; risks associated with the Company s dependence on third parties in the provision of transportation and other critical 2007 FINANCIAL REPORT BREAKWATER RESOURCES LTD. 33

36 services; risks associated with aboriginal title claims and other title risks; social and political risks associated with operations in foreign countries; and risks associated with legal proceedings. Actual results and developments are likely to differ, and may differ materially, from those expressed or implied by the forward-looking statements contained in this MD&A. Such statements are based on a number of assumptions which may prove to be incorrect, including, but not limited to, the following assumptions: that there is no material deterioration in general business and economic conditions; that there is no unanticipated fluctuation of interest rates and foreign exchange rates; that the supply and demand for, deliveries of, and the level and volatility of prices of zinc, copper, lead, gold and silver and the Company s other primary metals and minerals develop as expected; that the Company receives regulatory and governmental approvals for its development projects and other operations on a timely basis; that the Company is able to obtain financing for its development projects on reasonable terms; that there is no unforeseen deterioration in the Company s costs of production or production and productivity levels; that the Company is able to continue to secure adequate transportation for its products; that the Company is able to procure mining equipment and operating supplies (including tires) in sufficient quantities and on a timely basis; that engineering and construction timetables and capital costs for the Company s development and expansion projects are not incorrectly estimated or affected by unforeseen circumstances; that costs of closure of various operations are accurately estimated; that there are no unanticipated changes to market competition; that the Company s reserve estimates are within reasonable bounds of accuracy (including with respect to size, grade and recoverability) and that the geological, operational and price assumptions on which these are based are reasonable; that environmental and other proceedings or disputes are satisfactorily resolved; and that the Company maintains its ongoing relations with its employees and with its business partners and joint venturers. Readers are cautioned that the foregoing list of important factors and assumptions is not exhaustive. Forward-looking statements are not guarantees of future performance. Events or circumstances could cause the Company s actual results to differ materially from those estimated or projected and expressed in, or implied by, these forward-looking statements. Readers should also carefully consider the matters discussed under Risk Factors in the Company s Annual Information Form. The Company undertakes no obligation to update publicly or otherwise revise any forward-looking statements or the foregoing list of factors, whether as a result of new information or future events or otherwise, except as may be required under applicable laws. ACCOUNTING CHANGES Financial Instruments, Hedges and Comprehensive Income On January 1, 2007, the Company adopted the CICA s new accounting requirements for securities, hedging derivatives and certain other financial instruments. Under these new rules, the Company is required to measure certain securities and hedging derivatives at fair value and include a new section in Shareholders Equity, called Other Comprehensive Income, to report unrealized gains or losses related to: certain available-for-sale securities, cash flow hedges and foreign exchange gains or losses on the Company s net investment in foreign operations. Certain of the Company s investment securities (referred to as available-for-sale securities) are recorded at fair value under the new rules; however, the requirements for recognizing gains or losses in net income are unchanged. Unrealized gains or losses are deferred in Other Comprehensive Income until the securities are sold or there is an impairment that is other than temporary. It is only at that time that any gain or loss is recorded in net earnings. Securities whose sale is restricted or that are not traded in an active market are also included in available-for-sale securities, but continue to be recorded at cost. Any hedging derivatives that the Company enters into in the future will be recorded at fair value under the new rules, but changes in fair value will only impact net earnings to the extent that they do not perfectly offset changes in the fair value of the item that the Company is hedging (i.e.: hedge ineffectiveness). Any hedge ineffectiveness would be recorded in net earnings. For any of the Company s future hedging programs, it is expected that such hedges would very closely match the items that the Company hedges and, as a result, the Company would not expect a significant amount of hedge ineffectiveness to arise. For details of the specific accounting changes and related impacts, refer to note 2 of the Company s 2007 audited consolidated financial statements. 34 BREAKWATER RESOURCES LTD FINANCIAL REPORT

37 Management s Responsibility for Financial Reporting The accompanying consolidated financial statements of Breakwater Resources Ltd. (the Company ) and all of the information contained in the Financial Report are the responsibility of management and have been approved by the Company s Board of Directors. The consolidated financial statements have been prepared by management in accordance with Canadian generally accepted accounting principles. When alternative accounting methods exist, management has chosen those it deems most appropriate in the circumstances. Financial statements are not precise since they include certain amounts based on estimates and judgments. Management has determined such amounts on a reasonable basis in order to ensure that the consolidated financial statements are presented fairly, in all material respects. Management has prepared the financial information presented elsewhere in the Financial Report and has ensured that it is consistent with that in the consolidated financial statements. The Company maintains a system of internal accounting and administrative controls designed to provide reasonable assurance that the financial information is relevant, reliable and accurate and that the Company s assets are appropriately accounted for and adequately safeguarded. This system of internal control includes an organizational arrangement with clearly defined lines of responsibility. PricewaterhouseCoopers LLP, the independent auditors appointed by the shareholders to audit the consolidated financial statements, have full and unrestricted access to the Audit Committee. During the course of their audit, PricewaterhouseCoopers LLP reviewed the Company s system of internal control to the extent necessary to render their opinion on the consolidated financial statements. The Audit Committee is appointed by the Company s Board of Directors and all its members are outside directors. The Audit Committee meets periodically with management, as well as the independent auditors to discuss internal controls over the financial reporting process, auditing matters and financial reporting issues, to satisfy itself that each party is properly discharging its responsibilities and to review the consolidated financial statements and the independent auditors report. The Company s Audit Committee reports its findings to the Company s Board of Directors for consideration when approving the consolidated financial statements for issuance to shareholders. The Company s Audit Committee also considers, for review by the Company s Board of Directors and the approval by the shareholders, the engagement or reappointment of independent auditors. MANAGEMENT S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management is responsible for establishing and maintaining adequate control over financial reporting. Management conducted an evaluation of the effectiveness of internal control over financial reporting based on Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company s internal control over financial reporting was effective as at December 31, CONCLUSION RELATING TO DISCLOSURE CONTROLS AND PROCEDURES An evaluation was performed under the supervision of and with the participation of management, including the President and Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the Company s disclosure controls and procedures as defined in the Multilateral Instrument Based on that evaluation, the President and Chief Executive Officer and the Chief Financial Officer concluded that the design and operation of the Company s disclosure controls and procedures were effective as at December 31, George E. Pirie President and Chief Executive Officer David C. Langille Vice President, Finance and Chief Financial Officer 2007 FINANCIAL REPORT BREAKWATER RESOURCES LTD. 35

38 Auditors Report To the Shareholders of Breakwater Resources Ltd. We have audited the consolidated balance sheets of Breakwater Resources Ltd. as at December 31, 2007 and 2006 and the consolidated statements of operations and retained earnings (deficit), accumulated other comprehensive income (loss), other comprehensive income and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2007 and 2006 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants, Licensed Public Accoutants Toronto, Canada February 29, BREAKWATER RESOURCES LTD FINANCIAL REPORT

39 BREAKWATER RESOURCES LTD. Consolidated Balance Sheets (Expressed in thousands of Canadian dollars) As at December Assets Current Cash and cash equivalents 62,934 81,412 Restricted cash (note 3) 629 1,221 Short-term investments (note 4) 6,532 4,120 Accounts receivable concentrate 3,585 12,687 Other receivables 17,025 12,676 Concentrate inventory (note 5) 64,775 43,686 Materials and supplies inventory 29,096 22,904 Prepaid expenses and other current assets 7,541 4,029 Future income tax assets (note 16) 1,491 14,745 Total current assets 193, ,480 Future income tax assets, long-term (note 16) 17,632 13,440 Reclamation deposits (note 6) 33,500 13,500 Mineral properties and fixed assets (note 7) 267, ,884 Long-term investments (note 8) 32,922 14,704 Restricted promissory notes (note 11) 62,285 62, , ,293 Liabilities and Shareholders Equity Current Accounts payable and accrued liabilities 62,020 43,128 Provisional payments for concentrate inventory shipped and not priced 32,248 24,246 Short-term debt including current portion of long-term debt (note 9) 190 2,169 Income and mining taxes payable 10,078 9,798 Current portion of reclamation, closure cost accruals and other environmental obligations (note 12) 6,486 8,267 Total current liabilities 111,022 87,608 Deferred income (note 11) 5,666 6,277 Long-term lease obligations (notes 7 and 20) Royalty obligations (note 11) 82,479 62,479 Long-term debt (note 10) 1,851 Reclamation, closure cost accruals and other environmental obligations (note 12) 33,262 32,293 Employee future benefits (note 13) 2,817 4,493 Future income tax liabilities (note 16) 5,659 7,089 Total liabilities 243, ,740 Shareholders equity (note 14) 364, , , ,293 Contingencies and commitments (note 20). The accompanying notes form an integral part of these consolidated financial statements. Approved by the Board Garth A.C. MacRae Director George E. Pirie Director 2007 FINANCIAL REPORT BREAKWATER RESOURCES LTD. 37

40 BREAKWATER RESOURCES LTD. Consolidated Statements of Operations and Retained Earnings (Deficit) (Expressed in thousands of Canadian dollars except share and per share amounts) Years ended December Gross sales revenue 404, ,233 Treatment and marketing costs 100, ,847 Net revenue 304, ,386 Direct operating costs 161, ,572 Depreciation and depletion 22,791 17,558 Reclamation and closure costs 6,984 3, , ,853 Contribution from mining activities 112, ,533 General and administrative 15,679 14,047 Interest and financing 5,117 4,990 Investment and other income (3,146) (8,162) Foreign exchange and other 9,810 1,993 Exploration 17,036 9,973 Write-down of mineral properties and fixed assets (note 7) 16,000 Other non-producing property costs (income) (note 15) 2,153 (9,581) 62,649 13,260 Earnings before income and mining tax provision (recovery) 50, ,273 Income and mining tax provision (recovery) (note 16) 26,602 (1,257) Net earnings 23, ,530 Retained earnings (deficit), beginning of year 139,795 (189,663) Changes in accounting policy (note 2) 5,706 Reduction in stated share capital and contributed surplus (note 14(b)) 172,928 Retained earnings, end of year 168, ,795 Basic earnings per Common Share (note 23) $0.06 $0.41 Diluted earnings per Common Share (note 23) $0.05 $0.37 Basic weighted-average number of Common Shares outstanding (000 s) (note 23) 413, ,748 The accompanying notes form an integral part of these consolidated financial statements. 38 BREAKWATER RESOURCES LTD FINANCIAL REPORT

41 BREAKWATER RESOURCES LTD. Consolidated Statement of Accumulated Other Comprehensive Income (Loss) (Expressed in thousands of Canadian dollars) Year ended December Accumulated other comprehensive income, beginning of year (note 2) (7,689) Remeasurement of available-for-sale securities at January 1, 2007 (note 2) 11,980 Other comprehensive loss (8,108) Accumulated other comprehensive loss, end of year (note 14) (3,817) The accompanying notes form an integral part of these consolidated financial statements. BREAKWATER RESOURCES LTD. Consolidated Statement of Other Comprehensive Income (Expressed in thousands of Canadian dollars) Year ended December Net earnings 23,407 Other comprehensive income (loss), net of income taxes: Unrealized losses on translating financial statements of self sustaining foreign operations (9,386) Unrealized loss on short-term available-for-sale securities, net of income tax provision of $109 (note 4) (570) Unrealized gain on long-term available-for-sale securities, net of income tax provision of $352 (note 8) 1,848 Other comprehensive loss, net of income taxes (8,108) Comprehensive income 15,299 The accompanying notes form an integral part of these consolidated financial statements FINANCIAL REPORT BREAKWATER RESOURCES LTD. 39

42 BREAKWATER RESOURCES LTD. Consolidated Statements of Cash Flow (Expressed in thousands of Canadian dollars) Years ended December Operating Activities Net earnings 23, ,530 Items not affecting cash: Depreciation and depletion 22,791 17,558 Gain on sale of investment (306) Write-down of mineral properties and fixed assets (note 7) 16,000 Gain on sale of properties (note 15) (13,818) Unrealized loss on investments 7,601 Other non-cash items (4,418) (579) Stock-based compensation (note 14(f)) 2,149 1,608 Issue of common shares to settle litigation (note 14) 848 Unrealized deferred income (611) (611) Future income taxes (note 16) 7,594 (18,845) Reclamation, closure cost accruals and other environmental obligations 6,984 3,723 Employee future benefits (note 13) 1,483 2,139 Payment of reclamation, closure cost accruals and other environmental obligations (6,785) (7,439) Payment of employee future benefits (note 13) (3,159) (3,025) Changes in non-cash working capital items (note 22) 6,386 20,459 Net cash provided by operating activities 79, ,548 Investing Activities Decrease in restricted cash (note 3) 592 2,751 Reclamation deposits (20,000) (6,735) Short-term investments (5,055) (1,207) Mineral properties and fixed assets (113,782) (75,653) Proceeds from sale of mineral properties and fixed assets Net cash used in investing activities (137,941) (80,509) Financing Activities Proceeds from sale of royalty interest (note 11) 20,000 Issue of common shares for cash (note 14) 20,699 1,892 Deferred financing fees (223) Decrease in long-term lease obligations (234) (483) Decrease in short-term debt (118) (12,919) Decrease in long-term debt (3,643) Net cash provided by (used in) financing activities 40,347 (15,376) Net (decrease) increase in cash during the year (18,478) 62,663 Cash and cash equivalents, beginning of year 81,412 18,749 Cash and cash equivalents, end of year 62,934 81,412 Supplemental Information Cash interest paid Cash income and mining taxes paid 22,939 8,337 Cash interest received 4,299 2,086 The accompanying notes form an integral part of these consolidated financial statements. 40 BREAKWATER RESOURCES LTD FINANCIAL REPORT

43 BREAKWATER RESOURCES LTD. Notes to the Consolidated Financial Statements For the Years Ended December 31, 2007 and SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Generally accepted accounting principles The consolidated financial statements of Breakwater Resources Ltd. (the Company ) have been prepared in accordance with Canadian generally accepted accounting principles ( GAAP ). The more significant of the accounting policies are summarized as follows: Principles of consolidation The consolidated financial statements include the accounts of the Company and all of its subsidiaries all of which are controlled through the ownership of majority voting interests. All inter-company accounts and transactions have been eliminated on consolidation. Translation of foreign currencies - domestic and foreign operations The Company reports its financial statements in Canadian dollars, while the currency of measurement for the Company s operations varies depending upon location. The currency of measurement for the Company s operations domiciled in Canada is the Canadian dollar, while the currency of measurement for the Company s foreign operations is the United States ( US ) dollar, since all of the Company s revenue, and a substantial portion of its expenses relating to the foreign operations, are in US dollars. US dollar amounts for the Company s foreign operations are translated into Canadian dollars for reporting purposes using the current rate method. Under the current rate method, assets and liabilities are translated at the exchange rates in effect at the balance sheet date, revenues and expenses are translated at average rates for the year, and the resulting gains and losses are included in accumulated other comprehensive income (loss) which is a separate component of shareholders equity (note 14). As indicated above, the currency of measurement for the Company s foreign operations, including those in Honduras, Chile and Tunisia, is the US dollar. In each of these operations, the temporal method is used to translate local currency amounts into US dollars. Under the temporal method, all non-monetary items and the related income statement amounts are translated at the historical rates. Monetary assets and liabilities are translated at exchange rates in effect at the balance sheet date, while revenues and expenses, other than those related to non-monetary items, are translated at the average rate of exchange for the year, and gains and losses on translation are reflected in income for the year. Monetary assets and liabilities of the Company s domestic operations in Canada, denominated in US dollars, are translated at the rate of exchange at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses are translated at the average rate of exchange for the year. Exchange gains and losses are included in income for the year. Use of estimates The preparation of financial statements, in accordance with GAAP, requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the year. Actual results could differ significantly from those estimates. The assets and liabilities which require management to make significant estimates and assumptions in determining carrying values include accounts receivable, concentrate inventory, materials and supplies inventory, mineral properties and fixed assets, long-term investments, reclamation, closure cost accruals and other environmental obligations, future income tax assets and future income tax liabilities. Financial instruments The Company enters into derivative financial instrument contracts to manage certain market risks which result from the underlying nature of its business. When the Company chooses to apply hedge accounting, the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking the hedge transaction. This process includes linking all derivatives to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company may use forward contracts to hedge exposure to commodity price risk for metals production, and foreign exchange forward contracts to hedge exposure to fluctuations in foreign currencies, relating primarily to the US dollar and may designate these contracts as cash flow hedges as they occur. Hedge effectiveness is assessed 2007 FINANCIAL REPORT BREAKWATER RESOURCES LTD. 41

44 based on the degree to which the cash flow on the derivative contracts is expected to offset the cash flow of the underlying position or transaction being hedged. The Company also formally assesses, both at the hedge s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are, and continue to be, effective. Derivatives designated as hedges are carried on the consolidated balance sheets at their fair value. Unrealized gains and losses on effective cash flow hedges will be carried in Accumulated other comprehensive income ( AOCI ), a component of Shareholders equity on the consolidated balance sheets, while any gains or losses on ineffective hedges will be recognized in earnings. The premiums received at the inception of written call options are recorded as a liability and changes in the fair value of the liability are recognized currently in income. Contracts for which hedge accounting has not been applied, are classified as held-for-trading which are carried at their fair value and any gains and losses are recognized in the relevant period and included in Gross sales revenue on the consolidated statements of operations and retained earnings (deficit). Cash and cash equivalents Cash and cash equivalents include cash and highly liquid investments with original maturities of three months or less. The Company invests cash in term deposits maintained in high credit quality institutions. Short-term investments Short-term investments are designated as either held-for-trading or available-for-sale and are carried at their fair value. Unrealized gains and losses on held-for-trading securities are recognized in earnings and unrealized gains and losses on available-for-sale securities are recognized in Other comprehensive income ( OCI ). Concentrate inventory Concentrate inventory is valued at the lower of cost and net realizable value. Cost represents the weighted-average cost and includes direct labour and material costs, mine site overhead, depreciation and depletion. Materials and supplies inventory Materials and supplies inventory is valued at the lower of weighted average cost and replacement cost. Mineral properties and fixed assets The Company records its interest in mineral properties at cost and capitalizes development expenditures. When the properties are brought into commercial production, the capitalized costs are amortized on a units-of-production basis using current reserve estimates. If the properties are abandoned, the cost of the mineral property and any capitalized expenditures are written-down to fair value at that time. Administrative costs are expensed as incurred. Expenditures incurred to earn an interest in a joint venture are capitalized until the Company s interest is earned. The carrying values of producing mineral properties and fixed assets, including properties placed on a care and maintenance basis (note 15) are reviewed when events or changes in circumstances arise that may result in impairments in the carrying value of those assets. An impairment loss would be recognized when the carrying amount of a long-lived asset is not recoverable and exceeds the assets fair value which is based on the present value of expected future net cash flow. Estimated future net cash flow, on an undiscounted basis, is calculated for each property using: estimated recoverable reserves; estimated future metal price realization (considering historical and current prices, price trends and related factors); and, estimated operating, capital and other cash flow. Estimates of future cash flow are subject to risks and uncertainties. It is possible that changes could occur which may affect the recoverability of the carrying value of mineral properties. Fixed assets are stated at cost. Fixed assets are depreciated over their useful lives. In calculating depreciation, the Company employs the straight-line method and the units-of-production method. Principally, the rates of depreciation being applied, using the straight-line method, are intended to fully depreciate the related fixed assets over periods from 2 to 12 years. In accordance with EIC 152 Mining Assets Impairment and Business Combinations the Company includes value beyond proven and probable reserves in its estimate of future cash flow when testing for impairment and determining fair value. Development costs Development costs involve the preparation of identified reserves for production once the technical feasibility and commercial viability of the mineral deposit is established. These costs are capitalized. For a new mine, the development phase begins after the completion of a feasibility study and ends upon the commencement of commercial production. Development costs are amortized over the life of the area of interest from the date that commercial production of the related mineral occurs. Commercial production is deemed to have commenced when the Company determines that the completion of operational commissioning of major mine and plant components is completed, operating results are being achieved consistently for a period of time and there are indicators that these operating results will continue. 42 BREAKWATER RESOURCES LTD FINANCIAL REPORT

45 Long-term investments Long-term investments which are classified as held-for-trading or available-for-sale are carried at their fair value and those which are classified as held-to-maturity are carried at their amortized cost. Unrealized gains and losses on held-for-trading securities are recognized in earnings and unrealized gains and losses on available-for-sale securities are recognized in OCI. Asset retirement obligations and asset retirement costs The Company records the fair value of liabilities for asset retirement obligations in the year in which they are incurred. A corresponding increase in the carrying amount of the related asset is recorded and then depreciated over the life of the asset. Over time, the liability is accreted to its present value each year. Asset retirement obligations are provided for obligations that are required to be settled as a result of an existing law, regulation or contract related to asset retirements. Collateral on deposit with third parties to fund reclamation costs is included in Reclamation deposits and Restricted cash on the consolidated balance sheets. Employee future benefits The employee future benefits plan relates only to the employees at the Company s Myra Falls mine. The actuarial determination of the accrued benefit obligations for pensions and other retirement benefits uses the projected accrued benefit method prorated on service (which incorporates management s best estimate of the expected future return on plan assets, cost escalations, retirement ages of employees and other actuarial factors). For the purpose of calculating the expected return on plan assets, those assets are valued at fair value. Actuarial gains (losses) arise from the difference between the actual long-term rate of return on plan assets for a period and the expected long-term rate of return on plan assets for that period, or from changes in actuarial assumptions used to determine the accrued benefit obligation. The excess of the net accumulated actuarial gain (loss) over 10% of the greater of the benefit obligation and the fair value of plan assets is amortized over the lesser of the average remaining service period of active employees or to the date that Myra Falls mine operations are assumed to cease, which is currently December 31, The average remaining service period of the active employees covered by all plans is 5 years. Past service costs arising from plan amendments are deferred and amortized on a straight-line basis over the lesser of the average remaining service period of employees active at the date of amendment or to the date that mine operations are assumed to cease, December 31, Revenue recognition Revenue is recognized following the transfer of title and risk of ownership and the determination of the final settlement price in accordance with contractual arrangements with customers. Title is generally transferred on receipt of provisional payment from the customer. Risk is transferred either when the metal concentrate is delivered to the discharge port or to the load port depending on the terms of the contract. Under a delivered ex-ship term, risk passes when the concentrate is delivered to the discharge (destination) port. Under a cost, insurance and freight term, risk passes when the concentrate is delivered to the load (departure) port. Generally, the final settlement price is computed with reference to the average quoted metal prices for a specified period of time, normally one to three months subsequent to shipment to the customer. Concentrate sales and receivables are subject to adjustment on final determination of weights and assays. Provisional payments made by customers upon receipt of shipments of metal concentrate are classified as current liabilities captioned as Provisional payments for concentrate inventory shipped and not priced on the consolidated balance sheets. The Company produces zinc, copper, lead and gold concentrates. By-products such as gold and silver are often contained within concentrate shipped to customers and revenue from these by-products is recognized when all of the above revenue criteria are met and when the corresponding major metal is recognized in revenue. All concentrate revenues are recorded in gross sales revenue on the consolidated statements of operations and retained earnings (deficit). Exploration and evaluation expenditures The Company expenses all exploration and evaluation expenditures until the Company determines that the mineral deposit is deemed commercially viable, at which time all subsequent costs are capitalized. Exploration and evaluation expenditures on properties which do not have any known mineral deposits are expensed as incurred until a pre-feasibility study has been completed, after which, future development costs are capitalized if the pre-feasibility study demonstrates that future economic benefits are probable FINANCIAL REPORT BREAKWATER RESOURCES LTD. 43

46 Exploration and evaluation expenditures on properties adjacent to mineral deposits which are already being mined or developed are expensed until the Company is able to conclude that a future economic benefit is probable through the completion of a pre-feasibility study, after which the expenditure is capitalized as a mine development cost. Expenditures related to extensions of mineral deposits which are already being mined or developed, including expenditures on the definition of mineralization of such mineral deposits, is capitalized as a mine development cost following the completion of an economic evaluation which is equivalent to the completion of a pre-feasibility study. Properties purchased are recorded at fair value on the date of acquisition and are included in Mineral properties and fixed assets on the consolidated balance sheets. Income and mining taxes The provisions for income and mining taxes are based on the liability method. Future income taxes arise from the recognition of the tax consequences of temporary differences by applying substantively enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of certain assets and liabilities. The Company records a valuation allowance against any portion of those future income tax assets that it believes will, more likely than not, fail to be realized. Future withholding taxes are provided on the unremitted net earnings of foreign subsidiaries, to the extent that dividends or other repatriations are anticipated in the future and will be subject to such taxes. Share incentive plan The Company has a share incentive plan (the Plan ), which consists of a share purchase plan ( Share Purchase Plan ), a share option plan ( Share Option Plan ) and a share bonus plan ( Share Bonus Plan ), which is administered by the directors of the Company. The Plan provides that eligible persons thereunder include any director, full-time or part-time employee, officer or consultant of the Company or any subsidiary thereof. The Plan is described in note 14. The Company uses the fair value method of accounting to recognize an expense for stock-based compensation issued to employees through the Share Option Plan. The expense is recognized over the vesting period of the options. Common Shares issued under the Plan are recorded at the issue price. New pronouncements not adopted The Canadian Institute of Chartered Accountants ( CICA ) issued the following accounting standards effective for the fiscal years beginning on or after October 1, 2007 and January 1, 2008: a) Accounting Standards Section 3031 Inventories provides guidance on the determination of cost and its subsequent recognition as an expense, including any write-down to net realizable value. It also provides guidance on the cost formulas that are used to assign costs to inventories and is effective for the fiscal years beginning on or after January 1, The Company has not yet determined the impact of adopting this accounting standard. b) Accounting Standards Sections 3862 and 3863 Financial Instruments Disclosures and Presentation require disclosures in the financial statements that will enable users to evaluate: the significance of financial instruments for the company s financial position and performance; and the nature and extent of risks arising from financial instruments to which the company is exposed during the period and at the balance sheet date, and how the company manages those risks. These standards apply to interim and annual financial statements relating to fiscal years beginning on or after October 1, These standards will not affect the Company s consolidated results and will only impact the disclosure requirements figures Certain of the 2006 figures have been reclassified to conform to the 2007 presentation. 2. CHANGES IN ACCOUNTING POLICY On January 1, 2007, the Company adopted the following CICA accounting standards which were effective for fiscal years beginning on or after October 1, 2006 (i) Accounting Standards Section 1530 Comprehensive Income ; (ii) Accounting Standards Section 3855 Financial Instruments Recognition and Measurement ; (iii) Accounting Standards Section 3861 Financial Instruments Presentation and Disclosure ; and, (iv) Accounting Standards Section 3865 Hedges. These sections require certain financial instruments and hedge positions to be recorded at fair value. 44 BREAKWATER RESOURCES LTD FINANCIAL REPORT

47 Adoption of these standards is on a prospective basis without retroactive restatement of prior periods, except for the reclassification of equity balances to reflect AOCI which will include unrealized foreign currency translation adjustments for self-sustaining foreign operations. At January 1, 2007, the unrealized foreign currency translation loss for self-sustaining foreign operations of $7,689,000 was reclassified to AOCI and shown as Accumulated other comprehensive income, beginning of year. As required under CICA Section 1530 Comprehensive income, the consolidated financial statements now include consolidated statements of Other comprehensive income, which comprised net earnings and other comprehensive income. Other comprehensive income includes unrealized gains or losses related to available-for-sale securities, unrealized foreign exchange gains or losses on the net investment in self-sustaining foreign operations and reclassification of any realized gains or losses related to availablefor-sale securities to earnings. Under the new standard, financial instruments designated as held-for-trading and available-for-sale will be carried at their fair value while financial instruments such as loans and receivables, financial liabilities and those classified as held-tomaturity will be carried at their amortized cost. Unrealized gains and losses on financial instruments designated as held-fortrading are recognized in earnings and unrealized gains and losses on financial instruments designated as available-for-sale are recognized in OCI. All derivatives will be carried on the consolidated balance sheets at their fair value, including derivatives designated as hedges. Unrealized gains and losses on effective cash flow hedges will be carried in AOCI, a component of Shareholders equity on the consolidated balance sheets, while any gains or losses on ineffective hedges will be recognized in earnings. At the beginning of the fiscal year in which this standard was adopted, financial assets and financial liabilities were remeasured at fair value. Financial assets classified as held-for-trading and the adjustments of the previous carrying amounts are recognized as adjustments to opening retained earnings at the beginning of the fiscal year. The Company s policy is to recognize immediately in net income all transaction costs relating to financial instruments. At January 1, 2007, the adjustment of $5,706,000 to retained earnings at the beginning of the period related to the remeasurement of held-for-trading securities of $303,000 and the conversion rights in the long-term debentures of $5,403,000 (see notes 4 and 8). For financial assets classified as available-for-sale, the adjustments of the previous carrying amounts are included as an opening balance in AOCI. At January 1, 2007, the adjustment relating to the remeasurement of available-for-sale financial assets was $11,980,000 (see notes 4 and 8) and was included in AOCI. On October 1, 2007, the Company early adopted CICA Accounting Standard Section 1535 Capital disclosures which is effective for interim and annual financial statements relating to fiscal years beginning on or after October 1, As required under CICA Section 1535 the Company s objectives, policies and processes for managing capital are as follows: The Company s objectives when managing shareholders equity (see note 14) are to provide returns for shareholders and safeguard the ability to continue as a going concern. Mining is an inherently risky business which is capital intensive and, while the Company strives to achieve lowest quartile industry costs at all of its operations and meet cash flow requirements through internally generated cash flows, the Company periodically incurs significant debt to finance acquisitions and operational expansions and for working capital purposes. The Company monitors shareholders equity on the basis of long-term debt to total shareholders equity. For the years ended December 31, 2007 and 2006, the Company had a nominal level of debt which did not impose any capital constraints or restrictions on the Company. 3. RESTRICTED CASH The restricted cash balance at December 31, 2007, of $629,000 ( $1,221,000), includes $379,000 ( $971,000) placed on deposit to cover certain reclamation costs and $250,000 ( $250,000) to guarantee an operating lease FINANCIAL REPORT BREAKWATER RESOURCES LTD. 45

48 4. SHORT-TERM INVESTMENTS ($000 s) Marketable securities: Available-for-sale (quoted market value: $1,226) Held-for-trading (quoted market value: $4,275) 5,985 3,902 6,532 4,120 Marketable securities at December 31, 2007 are carried at fair value with the net unrealized loss on available-for-sale securities for the year ended December 31, 2007 of $570,000 recorded in OCI until realized and the unrealized loss of $3,345,000 on held-for-trading securities for the same period recorded in earnings. Marketable securities at December 31, 2006 were carried at cost, which was lower than the quoted market value. At January 1, 2007, the available-for-sale and held-for-trading securities were remeasured at fair value and the unrealized gains of $827,000 and $303,000 are included as an opening adjustment to the AOCI balance at the beginning of the year, and as an adjustment to opening retained earnings, respectively (see note 2). 5. CONCENTRATE INVENTORY Concentrate inventory as at December 31, 2007 includes an amount of $39,383,000 ( $20,245,000) for shipments where title and risk of ownership have been transferred to the customer but the final settlement price has not been determined. These shipments will be recognized as revenue in accordance with the Company s revenue recognition policy set out in note RECLAMATION DEPOSITS Cash collateral on deposit at December 31, 2007 of $33,500,000 ( $13,500,000), related to future reclamation activities, are held by third parties to fund reclamation costs at Myra Falls. The cash collateral on deposit at December 31, 2007 includes $20,000,000 which is funded through a qualifying environmental trust (see note 11(a)). 7. MINERAL PROPERTIES AND FIXED ASSETS ($000 s) Accumulated Accumulated depreciation Net book depreciation Net book Cost and depletion value Cost and depletion value Equipment 164, ,584 61, , ,757 50,288 Mineral properties, buildings and improvements 167,398 69,535 97, ,222 70,576 57,646 Development 142,424 35, , ,679 26,578 99,101 Asset retirement costs 9,551 8, ,997 9, , , , , , ,884 At December 31, 2007, the carrying value of the mineral properties and fixed assets at Myra Falls were written down by $16,000,000 as the net book value exceeded the fair value. Fair value was determine by using estimated future net cash flow which included; estimated recoverable reserves; future metal prices and foreign exchange rates; and, estimated operating and capital costs. The write-down of $16,000,000 was allocated against the fixed assets of Myra Falls on a pro-rata basis, based on the net book value before the write-down. Development costs are amortized using the unit-of-production method. The amortization expense for 2007 was $11,683,000 ( $4,657,000). Equipment under capital lease at December 31 was: ($000 s) Equipment cost 2,416 2,416 Less: accumulated amortization 1, , BREAKWATER RESOURCES LTD FINANCIAL REPORT

49 Equipment under capital lease is amortized on a straight-line basis over its economic life of five years. The amount of equipment lease costs that were amortized in 2007 is $483,000 ( $483,000). 8. LONG-TERM INVESTMENTS Long-term investments are classified as available-for-sale securities and are carried at fair value at December 31, At December 31, 2006, long-term investments were valued at cost, net of other than temporary impairments in value. The Company recorded, for the year ended December 31, 2007, an unrealized loss on the long-term investments of $2,055,000 which included an unrealized loss of $4,255,000 for the valuation of the conversion rights which are considered embedded derivatives and recorded through earnings and an unrealized gain of $2,200,000 for the increase in fair value of the debentures which are recorded in OCI, net of tax of $352,000. At January 1, 2007, the long-term investments were measured at fair value and the unrealized gain of $11,153,000 for the increase in fair value of the debentures was included in AOCI at the beginning of the year, and the unrealized gain of $5,403,000 relating to the remeasurement of the conversion rights was included in opening retained earnings (see note 2). ($000 s) Blue Note Mining Inc. unsecured convertible debenture 15,689 9,089 Taseko Mines Limited unsecured convertible debenture (fair market value: $10,569) 17,233 5,615 32,922 14,704 The unsecured subordinated convertible debenture from Blue Note Mining Inc. (formerly Blue Note Metals Inc.) ( Blue Note ) was issued on August 1, 2006 (note 15) in the amount of $15,000,000 and matures on August 1, The note does not bear interest and is unsecured. The debenture is convertible into common shares of Blue Note at the option of the Company, any time after the Caribou and Restigouche mines have been in commercial production for at least a twelve-month period (the Redemption Date ) and prior to the maturity date, at a price of $0.36 per share. The Company has the right to convert the debenture into a direct 20% property interest following commencement of commercial production and the expenditure by Blue Note of at least $1,500,000 of exploration on the properties. The Company will also receive a 1 to 2% net smelter return royalty payable quarterly on zinc metal production provided the average price of zinc for the quarter as determined by the London Metal Exchange is above US$0.65 per pound. Blue Note has the option to redeem the debenture any time after the Redemption Date and up to and including the maturity date by a cash payment or on maturity by issuing common shares at a price of $0.36 per share. Management determined the fair value of the debenture on acquisition to be $9,089,000. The unsecured convertible debenture from Taseko Mines Limited ( Taseko ) was issued on July 21, 1999, for $17,000,000 and matures on July 21, 2009 and does not bear interest. The debenture is convertible into common shares of Taseko over a ten-year period from the date of issuance commencing at a price of $3.14 per share escalating by $0.25 each year thereafter. From the fifth anniversary date until the tenth anniversary, the outstanding principal may, at the election of Taseko, be converted into common shares at the then prevailing share price. Management determined the fair value of the debenture on acquisition to be $5,615, SHORT-TERM DEBT ($000 s) Reimbursable government assistance, unsecured, non-interest bearing, current portion (note 10) 190 2,041 Other , LONG-TERM DEBT ($000 s) Reimbursable government assistance, unsecured, non-interest bearing 2,041 2,041 Less current portion 190 2,041 1, FINANCIAL REPORT BREAKWATER RESOURCES LTD. 47

50 In May 2007, the Company renegotiated the repayment terms for the reimbursable government assistance which relates to the Langlois mine with the government of Québec. The reimbursable government assistance consists of an amount of $500,000 relating to Zone 97 and $1,541,000 for the installation of a hydro line. The amount of $500,000 will be repaid with an instalment of $200,000 on January 1, 2009 and two instalments of $150,000 in the following two years and the amount of $1,541,000 will be repaid by an installment of $190,000 on April 1, 2008 and three annual instalments of $300,000 with a final installment on April 1, 2012 of $451, ROYALTY OBLIGATIONS a) In December 2007, the Company entered into a joint venture with the Myra Falls Mine Limited Partnership ( Partnership ) whereby the Partnership is entitled to a revenue interest of production from the Myra Falls mine consisting of a 3% net smelter royalty. The Partnership has deposited $20,000,000 with a trustee into a qualifying environmental trust ( QET ) as security for a portion of the reclamation obligations of NVI Mining Ltd., a wholly-owned subsidiary of the Company, which owns the Myra Falls mine. The $20,000,000 is included in Reclamation deposits and Royalty obligations on the consolidated balance sheets. A financing fee of $1,000,000 was paid and is included in Interest and financing on the consolidated statements of operations and retained earnings (deficit). The Company has the right to purchase the interests of the limited and general partners of the Partnership for approximately $18,000,000 (90.9% of the contribution to the QET) payable at the option of the Company in cash or common shares of the Company at the current market price, which is defined as the weighted-average of the trading price on the Toronto Stock Exchange ( TSX ) of the Company s Common Shares for the most recent twenty trading days ending the day before the exercise of the right. This right is exercisable from January 16, 2008 to April 15, If the Company does not exercise its right, the partners of the Partnership have the right to require the Company to purchase the interests of the limited and general partners of the Partnership for an amount equal to the fair market value of the revenue interest as determined by an appraisal. The purchase price is payable at the option of the Company in cash or Common Shares at the current market price on the day before the partners exercise their right but no less than the current market price the day before the agreements were entered into and a press release was issued. The partners may exercise their right from April 16, 2008 until May 15, b) In December 2005, the Company entered into a royalty agreement ( 2005 Second Royalty Agreement ) with Red Mile Resources No. 4 Limited Partnership ( Red Mile No.4 ) whereby the Company sold a basic royalty ( Second Basic Royalty ) on a portion of the payable zinc production over the life of the Myra Falls mine. The Company received cash of $56,500,000 which included royalty income of $50,500,000, indemnity fee income of $1,141,000, interest income of $4,469,000 and prepaid interest income of $390,000. In December 2004, the Company entered into a royalty agreement ( 2004 First Royalty Agreement ) with Red Mile Resources No. 5 Limited Partnership ( Red Mile No.5 ) whereby the Company sold a basic royalty ( First Basic Royalty ) on a portion of the payable zinc production over the life of the Myra Falls mine. The Company received cash of $13,540,000, which included royalty income of $11,979,000, indemnity fee income of $564,000, interest income of $520,000 and prepaid interest income of $477,000. Under the terms of the 2005 Second Royalty Agreement (2004 First Royalty Agreement), the Company is required to make Second Basic Royalty (First Basic Royalty) payments at fixed amounts per pound of payable zinc produced, which escalates from $ per pound to $ per pound (First Basic Royalty from $0.003 per pound to $0.016 per pound) over the first 12 years of the agreement. In addition, for the years 2011 through 2015 (Red Mile No.5 years 2010 through 2014), the Company granted Red Mile No.4 a net smelter return of 1.50%, 2.25% or 3.00% (Red Mile No.5 a net smelter return of 0.4%, 0.5% or 0.7%) if the average price of zinc in a given calendar year exceeds US$2,600, US$2,800 or US$3,000 per tonne (Red Mile No.5 average zinc prices of US$2,250, US$2,500 or US$2,750 per tonne), respectively. The Red Mile No.4 royalty income component of the cash received of $50,500,000 (Red Mile No.5 - $11,785,000) was placed with a financial institution for which the Company received a restricted promissory note. The restricted promissory note earns interest at 6% (Red Mile No.5 6%) per annum which is recorded in Investment and other income on the consolidated statements of operations and retained earnings (deficit) and matures on February 15, 2015 (Red Mile No.5 - December 15, 2014). Pursuant to the 2005 Second Royalty Agreement and the 2004 First Royalty Agreement, interest earned from the restricted promissory notes and a portion of the principal must be used to fund the expected basic royalty payments during the first ten years of each agreement. 48 BREAKWATER RESOURCES LTD FINANCIAL REPORT

51 Under certain circumstances, the Company has the right, by way of a call option, to acquire the partnership units of Red Mile No.4 and Red Mile No.5 for the lower of market value or the outstanding amount of the restricted promissory note at the end of the tenth year of the respective royalty agreements. The royalty income received from Red Mile No.5 and Red Mile No.4 is accounted for as debt. The long-term portion is included in Royalty obligations and the current portion is included in Accounts payable and accrued liabilities on the consolidated balance sheets. The deemed interest rate for these amounts under the 2005 Second Royalty Agreement and the 2004 First Royalty Agreement are 6.00% and 6.11% per annum respectively and the charges are included in Interest and financing on the consolidated statements of operations and retained earnings (deficit). The prepaid interest income and the indemnity fee received under the 2005 Second Royalty Agreement and the 2004 First Royalty Agreement have been recorded in Deferred income on the consolidated balance sheets and are being amortized into income over the life of the respective agreements reflected in Investment and other income on the consolidated statements of operations and retained earnings (deficit). As at December 31, 2007, prepaid interest income was $3,128,000 ( $3,575,000) and deferred indemnity fee was $1,198,000 ( $1,362,000). Total interest expense for the year ended December 31, 2007 was $3,796,000 ( $3,793,000) and total interest income for the year ended December 31, 2007 was $4,243,000 ( $4,240,000). 12. RECLAMATION, CLOSURE COST ACCRUALS AND OTHER ENVIRONMENTAL OBLIGATIONS ($000 s) Asset retirement obligations 32,874 33,015 Closure cost accruals 1,505 2,059 Other environmental obligations 5,369 5,486 39,748 40,560 Less current portion 6,486 8,267 33,262 32,293 Other environmental obligations represent expenditures required to complete modifications to the tailings facility at the Myra Falls mine. The Company expects to complete the required work by The estimated obligation was recorded and is being reduced by actual expenditures incurred. During the year, the provision for other environment obligations was increased by $3,233,000 for additional costs estimated to complete the modifications. The amount of $3,233,000 is included in Reclamation and closure costs on the consolidated statements of operations and retained earning (deficit). As at December 31, 2007, the expenditures since acquisition have been $12,728,000 ( $9,378,000). The current portion of $1,600,000 ( $2,001,000) is included in Current portion of reclamation, closure cost accruals and other environmental obligations on the consolidated balance sheets. Asset Retirement Obligations ($000 s) As at December 31, ,015 Change in timing of cash flow 6 Accretion (included in reclamation and closure costs) 2,577 Expenditures (1,995) Impact of foreign exchange (729) As at December 31, ,874 Less: current portion included in Current portion of reclamation, closure cost accruals and other environmental obligations 4,523 28,351 The estimated amount of undiscounted cash flow required to satisfy the asset retirement obligations as at December 31, 2007, was $98,102,000 ( $101,094,000). The expected timing of payments ranges from 2008 to 2119, and the credit-adjusted risk-free rates at which the estimated cash flow has been discounted to arrive at the obligation, ranges from 7.17% to 7.89% ( % to 7.89%). The estimated amount of undiscounted cash flow for December 31, 2007, includes an amount of $66,329,000 ( $66,329,000) which is for water treatment at Myra Falls in perpetuity FINANCIAL REPORT BREAKWATER RESOURCES LTD. 49

52 13. EMPLOYEE FUTURE BENEFITS The Company s unionized hourly employees at Myra Falls have a defined benefit pension plan with the employees benefits under this plan specified by a collective agreement. The pension plan is a flat benefit plan and there are no indexation features. The Company also provides extended health and dental benefits for certain employees and former employees of Myra Falls. The Company measures its accrued benefit obligations and the fair value of plan assets for accounting purposes as at December 31 of each year. Actuarial reports valuing this hourly plan are prepared every three years using the projected accrued benefit method, with December 31, 2004 being the most recent valuation and December 31, 2007 being the next required valuation which will be completed in The details of the Company s benefit plans as at December 31 are as follows: Pension Benefit Plans Other Benefit Plans (S000 s) Expected long-term rate of return on plan assets 7.0% 7.0% N/A N/A Discount rate on accrued pension obligations 5.50% 5.25% 5.50% 5.25% Rate of compensation increase N/A N/A N/A N/A Assumed health care cost trend rates at December 31: Initial health care cost trend rate 12.0% 12.0% Cost trend rate declines to 5.0% 5.0% Year that the rate reaches the rate it is assumed to remain at Dental care rate of expense increase 4.0% 4.0% Pension Benefit Plans Other Benefit Plans (S000 s) Pension expense Current service cost 1,396 1, Interest cost on accrued benefit obligation 2,140 2, Expected return on pension fund assets (2,343) (1,998) Amortization of experience gains/losses (11) 370 (27) (42) Amortization of past service cost ,398 2, Accrued benefit obligations Balance, beginning of year 40,223 39, Current service cost 1,396 1, Interest cost 2,140 2, Benefits paid (1,721) (1,403) (98) (95) Actuarial (gain) loss (1,258) (1,354) (4) 69 Balance, end of year 40,780 40, Plan assets Fair value, beginning of year 32,795 27,773 Actual return on plan assets 700 3,495 Employer contributions 3,061 2, Benefits paid (1,721) (1,403) (98) (95) Fair value, end of year 34,835 32,795 Funded status Fair value of plan assets 34,835 32,795 Accrued benefit obligations 40,780 40, Plan deficit (5,945) (7,428) (775) (826) Unamortized actuarial loss (gain) 2,993 2,597 (197) (220) Unamortized past service costs 864 1, Pension liability (2,088) (3,751) (729) (742) 50 BREAKWATER RESOURCES LTD FINANCIAL REPORT

53 The assumed health care cost trend rates can affect the amounts reported for the health care plan: Percentage 1 Percentage 1 Percentage 1 Percentage Point Point Point Point (S000 s) increase decrease increase decrease Effect on service cost 0.2 (0.3) 0.3 (0.2) Effect on interest cost 1.0 (1.6) 0.9 (0.8) Effect on year-end accrued benefit obligation 12.1 (11.3) 19.5 (29.5) Plan Assets The allocation of plan assets is set forth in the Investment Policy Statement. The Investment Policy Statement delegates authority to the Employee Benefits Committee to maintain and establish investment policies relating to the defined benefit plans. These policies and any changes to these policies are approved by the Board of Directors of a subsidiary of the Company. The subsidiary has adopted the following standards for the Employee Benefits Committee to follow when deciding how to invest the plan assets. Assets shall be invested: (a) in the sole interest of the plan participants and beneficiaries; (b) with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and of like aims; and (c) by diversifying the investments so as to minimize the risk of large losses as well as provide a reasonable rate of return on the assets. The following table summarizes the pension plan s weighted-average asset allocation percentages by asset category: ($000 s) Money market 7% 9% Fixed income 37% 42% Equity 56% 49% Total 100% 100% The benefit plan assets are managed by a major insurance company and the Company has chosen to invest in their diversified fund which has a target investment allocation of 40% - 60% in equity and 40% - 60% in fixed income. The diversified fund invests in several of its segregated funds, which include Canadian and foreign stocks, Canadian bonds and mortgages to achieve diversification. The performance objective of the diversified fund is to exceed the median rate of return of a representative sample of comparable funds over rolling five-year periods. The assumption for the expected long-term rate of return on plan assets is based on the relative weighting of plan assets, the historical experience of the portfolio and the review of projected returns by asset class on broad, publicly traded equity and fixed-income indices. Contributions The Company expects to contribute $2,803,000 to its defined benefit pension plan, $258,000 to the retirement supplements and $98,000 for its post-retirement benefit plans in Estimated future benefit payments Defined benefit ($000 s) pension plan Other benefits , , , , ,961 Aggregate of five years thereafter 11,974 At the December 31, 2004 actuarial report date, it was assumed that the mine would cease operations on December 31, Benefit payments are assumed to cease after December 31, 2011, for the retirement supplement plan, the voluntary early retirement allowance, and the other benefit plans, as the obligation related to these plans will cease once the Myra Falls mine ceases operation. No change was made to the defined benefit pension plan assumptions as pension payments are assumed to continue after the mine ceases FINANCIAL REPORT BREAKWATER RESOURCES LTD. 51

54 14. SHAREHOLDERS EQUITY Shareholders equity consists of the following: ($000 s) (restated see note 2) Capital stock 188, ,093 Warrants (j) 8,540 8,561 Contributed surplus 2, Retained earnings (note 2) 168, ,795 Accumulated other comprehensive income (note 2) (3,817) (7,689) 364, ,553 The Company is authorized to issue 200,000,000 preferred shares and an unlimited number of common shares ( Common Shares ). No preferred shares were issued or outstanding on December 31, 2007 and Common shares issued: Number of ($000 s) shares Amount $ As at December 31, , ,512 Reduction of stated capital (b) (169,628) Renunciation of flow-through share value (c) (2,346) Issue of Common Shares to settle a liability (d) Exercise of warrants (e) 1, Employee share option plan proceeds of options exercised (f) 2,805 1,538 Value ascribed to options exercised under stock-based compensation (f) 815 Employee share purchase plan (g) As at December 31, , ,093 Private placement (a) 6,123 11,988 Exercise of warrants (i) 30,802 6,160 Exercise of warrants (j) Reclassification of fair value of warrants exercised from Warrants (j) 21 Cancellation of shares (k) (121) (211) Employee share option plan proceeds of options exercised (f) 3,002 2,115 Value ascribed to options exercised under stock-based compensation (f) 1,124 Employee share purchase plan (g) As at December 31, , ,726 a) In December 2007, the Company issued 6,122,449 flow-through Common Shares by way of private placement at a price of $1.96 per Common Share exclusive of share issuance costs of $12,000 to a wholly-owned subsidiary of Dundee Corporation ( Dundee ). The flow-through Common Shares have a four-month hold period. Dundee is a significant shareholder of the Company. The proceeds of the flow-through shares will be used to finance exploration activities in Québec. b) At the annual and special meeting held on June 8, 2006, the shareholders approved a special resolution to reduce the stated capital of the Company by an amount of $172,928,000, which was equal to the accumulated deficit as at December 31, 2005 prior to a change in accounting policy. Capital stock was reduced by $169,628,000, contributed surplus was reduced by $3,300,000 and the deficit was reduced by $172,928,000. c) In February 2006, the Company renounced $7,380,000 in Canadian exploration expenses to investors of flow-through common shares in The tax value of the renunciation had been recorded as a liability and charged against share capital. Since the Company had a valuation allowance, which reduced the future income tax assets, the valuation allowance had been reduced and an income tax recovery had been recognized in the consolidated statements of operations and retained earnings (deficit). d) On June 12, 2006, the Company issued 750,000 Common Shares at a price of $1.13 per share to settle an outstanding lawsuit (note 15). 52 BREAKWATER RESOURCES LTD FINANCIAL REPORT

55 e) In consideration for restructuring certain credit facilities, the Company - pursuant to an agreement dated December 23, granted warrants to certain lenders and Dundee to purchase an aggregate of 2,000,000 and 1,000,000 Common Shares respectively, at $0.19 per Common Share with an expiry date of March 27, In 2006, 1,000,000 of these warrants were exercised by Dundee and, in 2005, 1,000,000 of these warrants were exercised by certain lenders. At December 31, 2007 and 2006, none of these warrants were outstanding. f) Share option transactions were as follows: Options (000 s) Weighted-average exercise price As at December 31, ,085 $0.88 Granted 3, Exercised (2,805) 0.55 Forfeited (478) 0.82 Expired (812) 2.20 As at December 31, ,535 $1.00 Granted 2, Exercised (3,002) 0.70 Forfeited (403) 2.06 Expired (310) 4.74 As at December 31, ,180 $1.31 As at December 31, 2007: Options Outstanding Options Exercisable Range of Shares Weighted-average Shares Exercise outstanding remaining Weighted-average exercisable Weighted-average Prices (000 s) contractual life exercise price (000 s) exercise price $ $0.50 2,054 3 years 138 days $0.33 2,054 $0.33 $ $1.50 3,047 2 years 179 days $0.95 2,538 $0.92 $ $3.00 2,869 4 years 85 days $2.22 1,330 $2.09 $ $ year 200 days $ $3.57 8,180 6,132 Pursuant to the Share Option Plan, the Board of Directors have the authority to grant options, and to establish the exercise price of the option at the time each option is granted, at a price not less than the closing price of the Common Shares on the TSX on the trading day immediately preceding the date of the grant of such option. Options issued after 2003 must be exercised no later than five years after the date of the grant, and options issued prior to 2003 must be exercised no later than ten years after the date of the grant and are subject to vesting provisions unless the Board of Directors of the Company determines otherwise. One third of the options become exercisable on each of: the date of granting such options; the first anniversary date of the date of granting such options; and, the second anniversary date of the date of granting such options. The outstanding share options at December 31, 2007 expire at various dates between April 13, 2008 and August 11, The number of shares available for grants of options under the share option plan as at December 31, 2007, was 21,001,464. On or after January 1, 2002, compensation expense for the stock-based compensation plan for employees under the Company s Share Option Plan has been determined based upon the fair value of awards granted. Stock-based compensation of $2,149,000 ( $1,608,000) less the initial fair value of options exercised of $1,123,000, ( $815,000), for a net amount of $1,026,000 ( $793,000) was credited to Contributed surplus within shareholders equity on the consolidated balance sheets. The proceeds of options exercised noted above were credited to Capital stock within shareholders equity on the consolidated balance sheets. The fair value of each option grant has been estimated using the Black-Scholes option-pricing model with the following weightedaverage assumptions: 2007 FINANCIAL REPORT BREAKWATER RESOURCES LTD. 53

56 Weighted-average exercise price per Common Share $2.38 $1.21 Weighted quoted market price per Common Share at date of grant $2.38 $1.21 Weighted-average grant-date fair value price per Common Share $1.21 $0.73 Expected life (years) Risk free interest rate 4.24% 4.32% Expected volatility 64% 69% Dividend yield 0% 0% g) Under the Share Purchase Plan, employees of the Company who fall under a certain classification can contribute up to 10% of their annual basic salary to purchase Common Shares. All other employees who qualify under the Share Purchase Plan can contribute up to 5% of their annual basic salary to purchase Common Shares. The Company matches each participant s contribution. The purchase price per Common Share is the weighted-average of the trading prices of the Common Shares on the TSX for the calendar quarter in respect of which the Common Shares are issued. Common Shares acquired with the Company s contribution are held in trust and delivered to employees 12 months following their date of issue. The Company issued 165,000 Common Shares pursuant to the Share Purchase Plan during 2007 ( ,000). The number of shares authorized for issue and available for issue under the share purchase plan as at December 31, 2007 was 8,500,000 (2006-8,500,000) and 3,054,940 (2006-3,220,393) respectively. h) At the annual and special meeting held on June 8, 2006, the shareholders approved a special resolution to amend the Plan to increase the maximum number of Common Shares of the Company that may be reserved for issuance for all purposes under the Plan from 34,500,000 to 54,500,000. The increase of 20,000,000 Common Shares was allotted as follows: (i) the number of Common Shares reserved for issuance under the Share Purchase Plan was increased by 1,000,000 (December 31, 2007 maximum 8,500,000); (ii) the number of Common Shares reserved for issuance under the Share Option Plan was increased by 18,000,000 (December 31, 2007 maximum 41,000,000); and, (iii) the number of Common Shares reserved for issuance under the Share Bonus Plan was increased by 1,000,000 (December 31, 2007 maximum 5,000,000). The Company s Share Bonus Plan permits Common Shares to be issued as a discretionary bonus to any director, full-time or part-time employee, officer or consultant of the Company, or any subsidiary thereof, who is designated under the Share Bonus Plan from time to time. As at December 31, 2007 and 2006, the Company had issued 1,200,000 Common Shares under the Share Bonus Plan and had available but un-issued at December 31, ,800,000 Common Shares (2006 3,800,000 Common Shares). i) In consideration for restructuring a debt facility in 2001 and 2002, Dundee received warrants to purchase an aggregate of 30,801,410 Common Shares at $0.20 per Common Share. One-half of these warrants were exercisable until March 2, 2007 and the remainder were exercisable until May 2, No value was ascribed to these warrants on the date of issue. On March 2, 2007 and March 14, 2007, Dundee exercised 15,400,705 and 15,400,705 warrants respectively to purchase 30,801,410 Common Shares at $0.20 per Common Share. At December 31, 2007, none of these warrants were outstanding (December 31, ,801,410). j) On January 28, 2004, the Company completed the sale of 57,142,858 units to a syndicate of underwriters at a purchase price of $0.70 per unit, for net proceeds of $37,027,000, net of costs of issue of approximately $2,973,000. Each unit consisted of one Common Share and one-half of one Common Share purchase warrant. Each whole warrant entitles the holder to acquire one Common Share at a price of $1.00 at any time until January 28, The fair value of the warrants of $7,211,000, net of costs of issue, is included in shareholders equity on the consolidated balance sheets as Warrants. On July 23, 2004, the Company acquired the Myra Falls mine for consideration which included 5,000,000 warrants exercisable at $1.00 per Common Share with an expiry date of January 28, The fair value ascribed to the warrants of $1,350,000 is included in shareholders equity on the consolidated balance sheets as Warrants. The above warrants are listed on the TSX and as at December 31, 2007 entitled warrants holders to acquire 33,488,329 (December 31, ,571,429) Common Shares of the Company. At December 31, 2007, the fair value of $21,000 ( $Nil) relating to warrants exercised was transferred from Warrants to share capital. k) In November 2000, the Company acquired Jascan Resources Inc. and as part of the purchase consideration issued 9,491,162 Common Shares at an ascribed value of $1.75 per share. Under the agreement any unclaimed Common Shares would be held in trust for a period of six years ( expiration ). After the expiration date any unclaimed Common Shares would revert back to the Company. In April 2007, 120,747 unclaimed Common Shares were released to the Company and were subsequently cancelled and the subscribed value of the common shares of $211,000 was transferred from share capital to contributed surplus. 54 BREAKWATER RESOURCES LTD FINANCIAL REPORT

57 15. OTHER NON-PRODUCING PROPERTY COSTS (INCOME) Due to the depletion of mineral reserves, the Company closed the Nanisivik, Bouchard-Hébert and Bougrine mines in September 2002, February 2005 and September 2005 respectively. The Company also suspended operations at the Caribou mine in In 2007, $2,026,000 ( $2,907,000) of care and maintenance costs were incurred on the Nanisivik, Bouchard-Hébert, Bougrine and Caribou mines. For the year ended December 31, 2006, other non-producing property income of $9,581,000 includes: (i) a gain of $13,818,000 on sale of the Caribou and Restigouche mines and (ii) a charge of $1,330,000 to settle a claim against the Company and CanZinco Ltd., a wholly-owned subsidiary of the Company, by Kalwea Financial Corp., BVI. On August 1, 2006, the Company sold the Caribou and Restigouche mines including certain assets and reclamation liabilities to Blue Note. Under the terms of the agreement, Blue Note replaced the Company s reclamation deposit of $5,852,000 with the Government of New Brunswick and issued to the Company a $15,000,000 unsecured subordinated convertible debenture with a maturity of five years (note 8). 16. INCOME AND MINING TAXES Income and mining taxes differ from the amount computed by applying the statutory federal income tax rate for the year ended December 31, 2007 of 35% ( %) to net earnings, excluding income and mining taxes. The differences are summarized as follows: ($000 s) Tax provision (recovery) at statutory rate 17,551 57,598 Federal resource allowance (1,548) Unrecognized tax benefit relating to losses 21,340 4,633 Current year losses recognized (20,232) Reduction in valuation allowance (2,345) Different effective tax rates on earnings (losses) in foreign subsidiaries (13,254) (13,034) Cost (benefit) of previously unrecognized losses available for carry forward 5,441 (25,777) Permanent timing differences and other (2,296) (6,516) Mining taxes (2,180) 5,964 26,602 (1,257) As at December 31, the significant components of the Company s future tax assets (liabilities) were as follows: ($000 s) Future tax assets Loss carry forwards 33,187 26,540 Mineral properties and fixed assets 232, ,237 Reclamation and closure cost accruals 10,673 12,721 Deferred income 1,915 2,104 Future tax assets before valuation allowance 278, ,602 Valuation allowance 259, ,417 Future tax assets 19,123 28,185 Future tax liabilities Mineral properties mining tax (5,659) (7,089) Net future tax assets 13,464 21,096 ($000 s) Income and mining tax provision (recovery) Current income and mining tax provision 23,219 14,209 Future income and mining tax provision (recovery) 3,383 (15,466) 26,602 (1,257) At December 31, 2007, the Company has net operating loss carry forwards in Canada of approximately $104,000,000, which expire at various dates through FINANCIAL REPORT BREAKWATER RESOURCES LTD. 55

58 17. FINANCIAL INSTRUMENTS The Company manages its exposure to fluctuations in commodity prices, foreign exchange rates and interest rates by entering into derivative financial contracts in accordance with the Company s formal risk management policy approved by the Board of Directors and managed by the Company s Hedging Committee. The Company does not hold or issue derivative contracts for speculative or trading purposes. The Company s short-term financial instruments, made up of cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities, and short-term debt are carried at cost which, due to their short-term nature, approximates their fair value. These fair value estimates are management s best estimates and are not necessarily indicative of the amounts the Company might pay or receive in actual market transactions. The amounts realized in an actual transaction may differ from these estimates. Potential taxes and other transaction costs have not been considered in estimating fair value. Credit Risk The Company is subject to credit risk through trade receivables. The Company manages this risk through evaluation and monitoring processes and carries credit insurance when necessary. Credit risk is further mitigated through the use of provisional payment arrangements and the use of letters of credit where appropriate. Credit risk also relates to derivative contracts arising from the possibility that a counterparty to an instrument in which the Company has an unrealized gain fails to perform. The Company does not consider the credit risk associated with these financial instruments to be significant. Foreign Exchange Risk The Company operates using principally the Canadian dollar and the US dollar, and may be negatively affected by fluctuations in foreign exchange rates. The Company manages this risk by minimizing the number of transactions that result in the settlement currency differing from the currency of the initial transaction. In addition, the Company s sales are denominated primarily in US dollars, while a significant percentage of its expenses are denominated in non-us dollars. This exposes the Company to increased volatility in earnings due to fluctuations in foreign exchange rates. The Company periodically uses forward foreign exchange contracts to hedge the exchange rates on identifiable foreign currency exposures. Gains and losses on these contracts when they are designated as hedges are reported as a component of the related transactions. The Company had no foreign exchange contracts outstanding at December 31, 2007 and Commodity Price Risk The profitability of the Company is directly related to the market price of metals produced. The Company reduces price risk by hedging against the price of metals for a portion of its production. The main tools used to protect against price risk are forward contracts and options. Various strategies are available using these tools including spot deferred and synthetic puts. The Company periodically enters into forward sales and options to effectively provide a minimum price for a portion of inventories and future production. In 2007 and 2006, the Company chose not to apply hedge accounting. As a result, outstanding derivative contracts were classified as held-for-trading and are carried at their fair value. Any gains and losses are recognized in the relevant period and included in Gross sales revenue on the consolidated statements of operations and retained earnings (deficit). The Company had no commodity hedges outstanding at December 31, 2007 and RELATED PARTY TRANSACTIONS All related party transactions are disclosed elsewhere in these consolidated financial statements (note 14) except for the following: a) As at December 31, 2007 and 2006, management fees payable to Dundee totalling $500,000 relating to $250,000 in each of 2003 and 2002 are outstanding and are included in Accounts payable and accrued liabilities on the consolidated balance sheets. b) For the year ended December 31, 2007, consulting fees of $50,000 ( $Nil) were paid to Dundee Securities Corporation, an affiliate of a significant shareholder of the Company. 56 BREAKWATER RESOURCES LTD FINANCIAL REPORT

59 19. GUARANTEES a) At December 31, 2007 and 2006, the Company has an outstanding letter of credit in the amount of $250,000 which is renewable annually and relates to the operating lease at the Nanisivik mine (note 3). b) In consideration for the receipt of indemnity fees of $564,000 and $1,141,000 from Wilshire Financial Services Inc. ( Wilshire ) related to the 2004 First Royalty Agreement (note 11(b)) and the 2005 Second Royalty Agreement (note 11(b)) respectively, the Company has indemnified and holds harmless Wilshire from and against any and all losses based upon, arising out of, or otherwise in connection with or as a result of any claims relating to a breach or default by the Company under the 2004 First Royalty Agreement and the 2005 Second Royalty Agreement. As at December 31, 2007, the maximum liability was $11,785,000 ( $11,785,000) and $50,500,000 ( $50,500,000) under the 2004 First Royalty Agreement and the 2005 Second Royalty Agreement respectively. The indemnity fees were deferred and are being amortized on a straight-line basis over the term of the respective agreements. 20. CONTINGENCIES AND COMMITMENTS a) On October 10, 2002, the Nunavut Water Board ( NWB ) issued to the Company a renewal of its water license, for a period of 5.5 years commencing on October 1, One of the conditions contained in the water license renewal was a requirement that the Company guarantee the financial security required by the license. The NWB established that the amount of security required by the license was $17,600,000. Of that amount $5,000,000 had been previously posted in the form of indemnity bonds pursuant to the expired water license. The issue of the outstanding balance of $12,600,000 was to have been addressed by the Company within 30 days of the issuance of the water license. In February 2003, the Company delivered to the Department of Indian Affairs and Northern Development ( DIAND ), the federal government agency responsible for the administration of financial security matters related to any water license issued by the NWB, an unsecured promissory note in the amount of $1,000,000 in order to satisfy the full requirement for financial security set out in the expired water license. On July 31, 2003, the indemnity bond in place in the amount of $5,000,000 to satisfy the previous water license expired, and it too was replaced by an unsecured promissory note issued by the Company. These two unsecured promissory notes satisfied the full requirement for financial security set out in the previous water license. Following the issuance of the new water license in October 2002, protracted discussions were held with DIAND regarding the form of security to be adopted to satisfy the financial security requirements of the new water license. Those discussions culminated in March 2005, when another unsecured promissory note was issued by the Company in the amount of $11,600,000 to satisfy the balance of the financial security requirement. With that transaction, the full amount of the financial security required, being $17,600,000, has been satisfied using unsecured promissory notes. b) Taseko and Gibraltar Mines Ltd. ( Gibraltar ) had notified Boliden Westmin (Canada) Limited ( BWCL ) (now a whollyowned subsidiary of the Company) and others in 2001 about indemnification claims made by Gibraltar pursuant to the asset purchase agreement entered into in 1999, whereby Gibraltar acquired certain assets from BWCL on July 21, In June 2006, Taseko and Gibraltar served a statement of claim on the Company and Boliden Ltd. (former parent corporation of BWCL). The claims were described as (a) latent tax liabilities estimated to be $3,750,000 relating to an environmental reclamation deposit that was transferred to Gibraltar, and (b) potential tax liability estimated to be in excess of $500,000 with respect to an employee severance trust (if this claim is successful, it exposes the Company to further direct liabilities which have not been quantified). In December 2006, the Company filed a statement of defense on its own behalf and on behalf of Boliden Ltd. in accordance with the indemnification obligations pursuant to the share exchange agreement dated July 8, 2004 between the Company and Boliden Ltd. While a final outcome cannot be determined at this early stage, the Company believes at this time that the claims are without substantial merit and that liability, if any, is not likely to have a material effect on the Company s financial position. c) In August, 2007, the Company and CanZinco Ltd. ( CanZinco ), a wholly-owned subsidiary of the Company, were added as defendants by counterclaim in a New Brunswick Court of Queen s Bench action by Merlin Group Securities Ltd., as Trustee of the Fern Trust (the Fern Trust ). The Plaintiff and defendant by counterclaim in the action is Blue Note which acquired the Caribou mine in New Brunswick from CanZinco in August 2006 (see note 8). At issue in the action is a 10% net profit interest ( NPI ) in the Caribou mine claimed by the Fern Trust. The claim against the Company and CanZinco, made in addition to the claim against Blue Note in the alternative, is for: (a) a declaration that CanZinco and the Company 2007 FINANCIAL REPORT BREAKWATER RESOURCES LTD. 57

60 are liable to the Fern Trust for its interest in the NPI; (b) damages in the amount of $40,000,000, or an amount calculated in accordance with the NPI based upon current market prices, whichever is greater, for breach of duties and obligations to the Fern Trust pursuant to the NPI, and; (c) prejudgment interest and costs of the action. On October 12, 2007, the Company and CanZinco served and filed statements of defence denying any liability whatsoever. The Company believes that this action is without merit and in any event expects to be indemnified by Blue Note under agreements entered into in connection with the Caribou mine sale transaction. The Company therefore anticipates that this claim is not likely to have a material effect on the Company s financial position. d) The Company is also involved in other legal proceedings and claims, which arise in the ordinary course of its business. The Company believes these claims are without merit and is vigorously defending them. In the opinion of the management, the amount of ultimate liability with respect to these actions will not materially affect the financial position, results of operations or cash flow of the Company. e) The Company s mining and exploration activities are subject to various federal, provincial and state laws and regulations governing the protection of the environment. These laws and regulations are continually changing and generally becoming more restrictive. The Company conducts its operations so as to protect public health and the environment and believes its operations are materially in compliance with all applicable laws and regulations. The Company has made, and expects to make in the future, expenditures to comply with such laws and regulations. f) Lease Commitments The Company is committed to payments for operating leases for business premises and equipment and future minimum lease payments under capital leases as follows: Operating Future Minimum ($000 s) Lease Payments Lease Payments , , and thereafter Sub-total 5, Less: amount representing interest at rates ranging from 4.1% to 9.0% N/A 63 5, SEGMENT INFORMATION The Company operates in the mining industry and has operating mines in Honduras (Mochito), Chile (Toqui) and Canada (Myra Falls and Langlois). The Langlois mine commenced commercial production on July 1, The Company has three mines which have been closed and are undergoing reclamation, two in Canada (Nanisivik and Bouchard-Hébert) and one in Tunisia (Bougrine). During 2006, the Company disposed of the Canadian Caribou and Restigouche mines which were on care and maintenance at the time of sale. The Company s operations produce a variety of concentrates for sale which are dependant on the particular mineralized deposits at each location and include zinc, copper, lead and gold concentrates some of which also contain silver and gold. The accounting policies adopted by these segments are the same as those described in the Summary of Significant Accounting Policies (note 1). The products and services in each of the reportable segments, except for corporate activities, are essentially the same, the reportable segments have been determined at the level where decisions are made on the allocation of resources and capital, and where internal financial statements are available. 58 BREAKWATER RESOURCES LTD FINANCIAL REPORT

61 Segment Information For the Year Ended December 31, 2007 Non- ($000 s) operating Corporate Operating Segment Mochito Toqui Myra Falls Langlois Total mines and Other Consolidated Gross sales revenue 130, , ,666 24, , ,335 Treatment and marketing costs (23,252) (40,245) (31,347) (5,444) (100,288) (100,288) Net revenue 106,753 74, ,319 19, , ,047 Direct operating costs (32,540) (28,262) (83,667) (17,145) (161,614) (161,614) Depreciation and depletion (4,374) (4,311) (8,839) (5,032) (22,556) (235) (22,791) Reclamation and closure costs (1,099) (276) (4,840) (101) (6,316) (668) (6,984) Contribution (loss) from mining activities 68,740 41,691 5,973 (2,843) 113,561 (668) (235) 112,658 General and administrative (15,679) (15,679) Interest and financing (5,117) (5,117) Investment and other income 3,146 3,146 Foreign exchange and other (9,810) (9,810) Exploration (2,919) (2,734) (3,328) (4,313) (13,294) (744) (2,998) (17,036) Write-down of mineral properties and fixed assets (16,000) (16,000) (16,000) Other non-producing property costs (2,026) (127) (2,153) Net earnings (loss) before income and mining tax (provision) recovery 65,821 38,957 (13,355) (7,156) 84,267 (3,438) (30,820) 50,009 Income and mining tax (provision) recovery (19,132) (5,919) (18,890) 15,470 (28,471) (67) 1,936 (26,602) Net earnings (loss) 46,689 33,038 (32,245) 8,314 55,796 (3,505) (28,884) 23,407 Capital expenditures 23,130 26,738 21,362 35, ,335 7, ,782 Mineral properties and fixed assets 34,848 41,152 60, , ,367 5,233 8, ,462 Identifiable assets 57,202 66, , , ,618 6, , ,409 Information about major customers Summary of net revenue from major customers for the year ended December 31, Revenue Source ($000 s) Mochito Toqui Myra Falls Total Customer 1 32,481 28,556 7,146 68,183 Customer 2 19,892 34,844 54,736 Customer 3 19,640 3,903 24,712 48, FINANCIAL REPORT BREAKWATER RESOURCES LTD. 59

62 Segment Information For the Year Ended December 31, 2006 Non- ($000 s) operating Corporate Operating Segment Mochito Toqui Myra Falls Langlois Total mines and Other Consolidated Gross sales revenue 157,051 99, , ,585 (52) (4,300) 452,233 Treatment and marketing costs (40,477) (30,277) (57,161) (127,915) 68 (127,847) Net revenue 116,574 69, , , (4,300) 324,386 Direct operating costs (31,765) (18,941) (83,866) (134,572) (134,572) Depreciation and depletion (5,639) (2,812) (8,929) (17,380) (178) (17,558) Reclamation and closure costs (770) (298) (1,473) (100) (2,641) (1,082) (3,723) Contribution (loss) from mining activities 78,400 47,448 48,329 (100) 174,077 (1,066) (4,478) 168,533 General and administrative (14,047) (14,047) Interest and financing (4,990) (4,990) Investment and other income 8,162 8,162 Foreign exchange and other (1,232) (1,232) (761) (1,993) Exploration (1,235) (4,145) (617) (5,997) (3,989) 13 (9,973) Other non-producing property (costs) income 9,637 (56) 9,581 Net earnings (loss) before income and mining tax (provision) recovery 77,165 43,303 46,480 (100) 166,848 4,582 (16,157) 155,273 Income and mining tax (provision) recovery (20,365) (1,781) 26,202 (5,167) (1,111) 2,368 1,257 Net earnings (loss) 56,800 41,522 72,682 (5,267) 165,737 4,582 (13,789) 156,530 Capital expenditures 9,603 8,363 16,596 39,535 74,097 1,556 75,653 Mineral properties and fixed assets 21,502 24,669 64,844 89, ,425 5,757 1, ,884 Identifiable assets 40,248 51, ,110 93, ,766 9, , ,293 Information about major customers Summary of net revenue from major customers for the year ended December 31, Revenue Source ($000 s) Mochito Toqui Myra Falls Total Customer 1 5,037 62,635 67,672 Customer 2 8,635 1,564 50,905 61,104 Customer 3 1,593 24,236 7,946 33, BREAKWATER RESOURCES LTD FINANCIAL REPORT

63 22. ANALYSIS OF CHANGES IN NON-CASH WORKING CAPITAL ITEMS ($000 s) Accounts receivable concentrate 21,954 (8,187) Other receivables (12,743) (3,307) Concentrate inventory (21,150) 4,228 Materials and supplies inventory (8,823) (1,478) Prepaid expenses and other current assets (3,685) 82 Accounts payable and accrued liabilities 22,194 10,070 Provisional payments for concentrate inventory shipped and not priced 8,002 9,471 Income and mining taxes payable 637 9,580 6,386 20, EARNINGS PER COMMON SHARE Basic earnings per Common Share ( EPS ) has been calculated using the weighted-average number of shares outstanding during the year. The calculation of diluted earnings per Common Share has been computed using the treasury stock method which assumes that options and warrants with an exercise price lower than the average quoted market price were exercised at the later of the beginning of the period, or time of issue. In applying the treasury stock method, options and warrants with an exercise price greater than the average quoted market price of the Common Shares are not included in the calculation of diluted earnings per Common Share as the effect is anti-dilutive. The average quoted market price of the Common Shares during 2007 was $2.33 ( $1.30) Basic earnings per Common Share $0.06 $0.41 Diluted earnings per Common Share $0.05 $0.37 Basic weighted-average number of Common Shares outstanding (000 s) 413, ,748 Incremental Common Shares on assumed exercise of options and warrants (000 s) 28,089 37,757 Weighted-average number of Common Shares used for diluted earnings per Common Share (000 s) 441, , SUBSEQUENT EVENTS On January 8, 2008, the Company reached an agreement with Metco Resources Inc. ( Metco ) whereby the Company will purchase 100% of Metco for 7,000,000 Common Shares of the Company. This agreement is subject to normal closing conditions including the approval of regulatory authorities and Metco shareholders at a special and general meeting expected to be held mid-march FINANCIAL REPORT BREAKWATER RESOURCES LTD. 61

64 Corporate Information DIRECTORS Garth A. C. MacRae Chairman Grant A. Edey 1, 5 Joanne Ferstman 1 1, 3, 4 Jonathan C. Goodman 4, 5 Ned Goodman 2 John W. Ivany W. Murray John 3 George E. Pirie 3, 5 A. Murray Sinclair, Jr. 2, 4 1 Member of Audit Committee 2 Member of Compensation Committee 3 Member of Hedging Committee 4 Member of Corporate Governance and Nominating Committee 5 Member of Environmental, Health and Safety Committee CORPORATE AND REGISTERED OFFICE 95 Wellington Street West Suite 950 Toronto, ON M5J 2N7 Tel: (416) Fax: (416) investorinfo@breakwater.ca OFFICERS George Pirie President and Chief Executive Officer Dave Langille Vice President, Finance and Chief Financial Officer Bill Heath Executive Vice President Fred Hermann Senior Vice President, Sustainability Bert Boivin Vice President, Canada Bob Carreau Vice President, CSR and Sustainability Dr. Bob Cuttriss Vice President, Technical Services Daniel Goffaux Vice President, Latin America Steve Hayes Vice President, Commercial Torben Jensen Vice President, Engineering Wes Roberts Vice President, Corporate Development Ann Wilkinson Vice President, Investor Relations and Assistant Secretary Leroy Fong Controller Lesley Duncan Interim Corporate Secretary 62 BREAKWATER RESOURCES LTD FINANCIAL REPORT

65 Shareholder Information TRANSFER AGENT AND REGISTRAR Computershare Investor Services Inc. 100 University Ave. 9th Floor Toronto, ON M5J 2Y1 North America Toll-free Tel: (800) Fax: (888) International Tel: (514) Fax: (416) CO-TRANSFER AGENTS Computershare Investor Services Inc. 510 Burrard Street 2nd Floor Vancouver, BC V6C 3B9 Computershare Trust Company N.A. 350 Indiana Street Suite 800 Golden, Colorado U.S.A Tel: (303) Fax: (303) SHARES AND WARRANTS Toronto Stock Exchange (TSX) Symbols - BWR & BWR.WT WEBSITE FINANCIAL REPORT BREAKWATER RESOURCES LTD. 63

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