Critical accounting policies

Financial assets and financial liabilities in UBS’s trading portfolio, financial assets and liabilities designated at fair value, derivative instruments, and financial assets available-for-sale are recorded at fair value on the balance sheet. Changes in the fair value of these financial instruments are recorded in Net trading income in the income statement, except for financial assets available-for-sale, for which changes in fair value are recorded directly in equity until realized or the assets are considered impaired. Key judgments affecting this accounting policy relate to how UBS determines fair value for such assets and liabilities.

Where no active market exists, or where quoted prices are not otherwise available, UBS determines fair value using valuation techniques. In these cases, fair values are estimated from observable data in respect of similar financial instruments, using models to estimate the present value of expected future cash flows or other valuation techniques, using inputs existing at the balance sheet dates. If available, market observable inputs are applied to valuation models (level 2). In cases where market observable inputs are not available for all significant valuation parameters, they are estimated based on appropriate assumptions (level 3). At 31 December 2008, financial assets categorized as level 2 amounted to CHF 965 billion (31 December 2007: CHF 799 billion) and those categories as level 3 amounted to CHF 57 billion (31 December 2007: CHF 76 billion). At 31 December 2008, financial liabilities categorized as level 2 amounted to CHF 931 billion (31 December 2007: CHF 615 billion) and level 3 to CHF 46 billion (31 December 2007: CHF 59 billion).

Valuation models are used primarily to value derivatives transacted in the over-the-counter market, including credit derivatives, unlisted equity and debt securities (including those with embedded derivatives), and other debt instruments for which markets were or have become illiquid in 2008. All valuation models are validated before they are used as a basis for financial reporting, and periodically reviewed thereafter, by qualified personnel independent of the area that created the model. Wherever possible, UBS compares valuations derived from models with prices of similar financial instruments, and with actual values when realized, in order to further validate and calibrate UBS’s models.

A variety of factors are incorporated in UBS’s models, including actual or estimated market prices and rates, such as time value and volatility, and market depth and liquidity. Where available, UBS uses market observable prices and rates derived from market verifiable data. Where such factors are not market observable, changes in assumptions could affect the reported fair value of financial instruments. UBS generally applies its models consistently from one period to the next, ensuring comparability and continuity of valuations over time. However, models are changed or adapted to market developments in situations where peviously used models have limitations and are assessed to be inadequate.

Estimating fair value inherently involves a significant degree of judgment. Management therefore establishes valuation adjustments to cover the risks associated with the estimation of unobservable input parameters and the assumptions within the models themselves. Valuation adjustments are also made to reflect such elements as deteriorating creditworthiness (in247 Financial information cluding country-specific risks), concentrations in specific types of instruments and market risk factors (interest rates, currencies, etc.), and market depth and liquidity. Although a significant degree of judgment is, in some cases, required in establishing fair values, management believes that the fair values recorded in the balance sheet and the changes in fair values recorded in the income statement are reflective of the underlying economics, based on UBS’s established fair value and model governance policies and the related controls and procedural safeguards UBS employs. For a description of the valuations of UBS’s positions related to the US student loan auction rate securities, monolines, leveraged finance transactions, US and non-US reference linked notes, US commercial mortgage backed securities and other instruments which were determined relevant for specific disclosure refer to Note 27.

Uncertainties associated with the use of model-based valuations (both level 2 and level 3) are predominantly addressed through the use of model reserves. These reserves reflect the amounts that UBS estimates are appropriate to deduct from the valuations produced directly by the models to reflect uncertainties in the relevant modeling assumptions and inputs used. In arriving at these estimates, UBS considers the range of market practice and how it believes other market participants would assess these uncertainties. Model reserves are periodically reassessed in light of information from market transactions, pricing utilities, and other relevant sources. The level of these model reserves is, nevertheless, to a large extent a matter of judgment.

To estimate the potential effect on the Financial Statements from the use of alternative valuation techniques or assumptions, UBS makes use of the model reserve amounts described above, by scaling the level of the model reserves higher and lower, to assess the impact on valuation of increasing or decreasing the amount of model-related uncertainty considered.

The potential effect of using reasonably possible alternative valuation assumptions has been quantified as follows:

Source: Annual report 2008, section Financial information