Critical accounting policies

IFRS 2 requires that shares and share options awarded to employees are recognized as compensation expense based on their fair value at grant date. In valuing share awards, the employee’s entitlement to receive dividends during the vesting period and post-vesting sale and hedge restrictions and non-vesting conditions are taken into account. The share options UBS issue to its employees have features that make them incomparable to options on UBS’s shares traded in active markets. Accordingly, UBS cannot determine fair value by reference to a quoted market price, but UBS rather estimates it using an option valuation model. The model, a Monte Carlo simulation, requires inputs such as interest rates, expected dividends, volatility measures and specific employee exercise behavior patterns based on statistical data.

Some of the model inputs UBS uses are not market observable and have to be estimated or derived from available data. Use of different estimates would produce different option values, which in turn would result in higher or lower compensation expense recognized. Several recognized models for the valuation of options exist but none can be singled out as the best or most correct. The model UBS applys has been selected because it is able to handle some of the specific features included in the options granted to UBS’s employees. If UBS was to use a different model, the option values produced would be different, even if it used the same inputs.

Using both different inputs and a different valuation model could have a significant impact on the fair value of employee share options, which could be either higher or lower than the values produced by the model UBS applys and the inputs it has used.

On 1 January 2008, UBS adopted an amendment to IFRS 2 Share-based Payment: Vesting Conditions and Cancellations and restated the two comparative prior years. The amended standard no longer considers non-compete conditions to establish a service requirement in order to earn the share-based awards. Accordingly, UBS changed its expense recognition for compensation awards that contain non-compete conditions from the stated vesting period to the period over which the employee is required to provide active service in order to earn the award. Post-vesting sale and hedge restrictions and other non-vesting conditions are considered when determining the fair value of an award at grant date. The adoption of these IFRS 2 amendments had the effect that the compensation expense for share and option awards containing non-compete provisions was recognized retrospectively in the year for which the award was granted. Additional compensation expense of CHF 797 million was recognized for 2007 and CHF 516 million for 2006.

In 2008, management decided that most of the share-based awards to be granted in March 2009 for the year 2008 will be forfeited if the employee terminates employment with UBS prior to vesting and eliminated the non-compete conditions. Compensation expense for these awards will be recognized over the stated vesting period that commences on 1 March 2009. The adoption of the amendments to IFRS 2 and the large reduction in variable compensation for 2008 resulting in a small number of share grants related to 2008 significantly reduced share-based compensation expense for 2008.

Further information on UBS equity compensation plans is disclosed in Note 1a) 22) and Note 31 to the Financial Statements.

Source: Annual report 2008, section Financial information