Critical accounting policies

Basis of preparation and selection of policies

UBS prepares its Financial Statements in accordance with IFRS as issued by the International Accounting Standards Board. The application of certain of these accounting principles requires considerable judgment based upon estimates and assumptions that involve significant uncertainty at the time they are made. Changes in assumptions may have a significant impact on the Financial Statements in the periods where assumptions are changed. Accounting treatments where significant assumptions and estimates are used are discussed in this section, as a guide to understanding how their application affects the reported results. A broader and more detailed description of the accounting policies UBS employs is shown in Note 1 to the Financial Statements.

The application of assumptions and estimates means that any selection of different assumptions would cause the reported results to differ. UBS believes that the assumptions it has made are appropriate, and that UBS's Financial Statements therefore present the financial position and results fairly, in all material respects. The alternative outcomes discussed below are presented solely to assist the reader in ­understanding UBS's Financial Statements, and are not in­tended to suggest that other assumptions would be more appropriate.

Many of the judgments UBS makes when applying accounting principles depend on an assumption, which UBS ­believes to be correct, that UBS maintains sufficient liquidity to hold positions or investments until a particular trading strategy matures - i. e. that UBS does not need to realize positions at unfavorable prices in order to fund immediate cash needs. Liquidity is discussed in more detail in the ­"Liquidity and funding management" section of this report.

Fair value of financial instruments

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 (including 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:

- Scaling the model reserve amounts upward in line with less favorable assumptions would reduce fair value by ap­proximately CHF 2.5 billion at 31 December 2008, by ­approximately CHF 2.7 billion at 31 December 2007 and approximately CHF 1.0 billion at 31 December 2006.

- Scaling the model reserve amounts downward in line with more favorable assumptions would increase fair ­value by approximately CHF 1.4 billion at 31 December 2008, approximately CHF 2.2 billion at 31 December 2007, and approximately CHF 1.0 billion at 31 December 2006.

Refer to Note 27 for additional sensitivity information for se­ve­ral relevant products.

Goodwill impairment test

The ongoing crisis in the financial markets dramatically changed industry dynamics and the related decrease in market capitalization of UBS made it necessary to monitor closely whether there was indication that goodwill allocated to its cash-generating units was impaired. At 31 December 2008, equity attributable to UBS shareholders stood at CHF 33 billion. UBS's market capitalization, excluding the shares to be issued upon conversion of the MCNs, amounted to CHF 44 billion at 31 December 2008. On the basis of the impairment testing methodology described in Note 16, UBS concluded that the year-end 2008 balances of goodwill allocated to all its segments remain recoverable. Goodwill allocated to the Investment Bank at 31 December 2008 amounted to CHF 4.3 billion (CHF 5.2 billion at 31 December 2007), to Wealth Management US CHF 3.7 billion, Wealth Management International & Switzerland CHF 1.6 billion and Global Asset Management CHF 2.0 billion. The assessment of the goodwill in the Investment Bank, which is most affected by the financial market crises, was a key focus.

In its review of the year-end 2008 goodwill balance, UBS considered the performance outlook of its Investment Bank division and the underlying business operations to resolve whether the recoverable amount for this unit covers its carrying amount. Based on the estimated cash flows the Investment Bank will generate from its businesses, discounted back to their present value using a discount rate that reflects the risk profile of the Investment Bank's activities, UBS concluded that goodwill allocated to the Investment Bank remained recoverable on 31 December 2008. The conclusion was reached on the basis of the forecast results of those ­activities which management expects to generate positive cash flows in future years. The forecasts are based on an expectation that the economic environment will gradually improve over the next three years and reach an average growth level thereafter. The fair value obtained from the model calculation was subject to a stress test by decreasing forecast cash flows by one third and at the same time increasing the discount rate by 3.5 percentage points to 16.5%. The stress value covered the book value of the Investment Bank. However, if the conditions in the financial markets and banking industry further deteriorate and turn out to be worse than anticipated in UBS's performance forecasts, the goodwill carried in the ­Investment Bank business division may need to be impaired in future periods.

The same model is applied to all segments carrying goodwill. It is most sensitive to changes in the forecast earnings available to shareholders in year one to five, the estimated return on equity, the underlying equity, the cost of equity and to changes in the long-term growth rate. The applied long-term growth rate is based on long-term risk-free interest rates. Earnings available to share­holders are estimated based on forecast results, business ­ini­tiatives and planned capital investments and returns to shareholders. Valuation parameters used within the Group's impairment test model are linked to external market ­in­formation, where applicable. Management believes that reasonable changes in key assumptions used to determine the recoverable amounts of all segments will not result in an impairment situation.

Reclassification of financial instruments

The International Accounting Standards Board published an amendment to International Accounting Standard 39 (IAS 39 Financial Instruments: Recognition and Measurement) on 13 October 2008, under which eligible financial assets, subject to certain conditions being met, may be reclassified out of the "held for trading" category if the firm has the intent and ability to hold them for the foreseeable future or until maturity.

Although the amendment could have been applied retrospectively from 1 July 2008, UBS decided at the end of October 2008 to apply the amendment with effect from 1 October 2008 following an assessment of the implications on its financial statements.

Effective 1 October 2008, UBS reclassified eligible assets which it intends to hold for the foreseeable future with a fair value of CHF 17.6 billion on that date from "held for trading" to the "loans and receivables" category. In addition, student loan auction rate securities (ARS) with a fair value of CHF 8.4 billion have been reclassified as of 31 December 2008. In fourth quarter 2008, an impairment charge of CHF 1.3 billion was recognized as credit loss expense on reclassified financial instruments. If reclassification had not occurred, the impairment charge would not have been recognized but an additional trading loss of CHF 4.8 billion would have been recorded in UBS's fourth quarter income statement. Net interest income after reclassification increased by CHF 0.1 billion. Refer to Note 29 for details.

Consolidation of Special Purpose Entities

UBS sponsors the formation of Special Purpose Entities (SPEs) primarily to allow clients to hold investments in separate legal entities, to allow clients to jointly invest in alternative assets, for asset securitization transactions and for buying or selling credit protection. In accordance with IFRS, UBS does not consolidate SPEs that it does not control. In order to determine whether UBS control an SPE or not, UBS has to make judgments about risks and rewards and assess the ability to make operational decisions for the SPE in question. In many instances, elements are present that, considered in isolation, indicate control or lack of control over an SPE, but when considered together make it difficult to reach a clear conclusion. When assessing whether UBS has to consolidate an SPE it evaluates a range of factors, including whether (a) the activities of the SPE are being conducted on UBS's behalf according to its specific business needs so that UBS obtains the benefits from the SPE's operations, or (b) UBS has decision-making powers to obtain the majority of the benefits of the activities of the SPE, or UBS has delegated these decision-making powers by setting up an autopilot mechanism, or (c) UBS has the rights to obtain the majority of the benefits of the activities of an SPE and therefore may be exposed to risks arising from the activities of the SPE, or (d) UBS retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain the benefits from its activities. UBS consolidates a SPE if its assessment of the relevant factors indicates that UBS controls the SPE.

SPEs used to allow clients to hold investments are structures that allow one or more clients to invest in an asset or set of assets, which are generally purchased by the SPE in the open market and not transferred from UBS. The risks and rewards of the assets held by the SPE reside with the clients. Typically, UBS will receive service and commission fees for ­creation of the SPE, or because it acts as investment manager, custodian or in some other function. Many of these SPEs are single-investor or family trusts while others allow a broad number of investors to invest in a diversified asset base through a single share or certificate. These latter SPEs range from mutual funds to trusts investing in real estate. The majority of UBS's SPEs are created for client investment purposes and are not consolidated. However, UBS consolidates investment funds in cases where it provides or have a moral obligation to provide financial support to a fund. In these instances UBS generally assumes the majority or a significant portion of the risks of the fund, which, combined with UBS's role as investment manager, makes the party that can ­exercise control over the entity.

SPEs used to allow clients to jointly invest in alternative assets, e. g. feeder funds, for which generally no active ­markets exist, are often in the form of limited partnerships. Investors are the limited partners and contribute all or the ­majority of the capital, whereas UBS serves as the general partner. In that capacity, UBS is the investment manager and have sole discretion over investment and other administrative decisions, but have no or only a nominal amount of capital invested. UBS typically receives service and commission fees for UBS's services as general partner but do not, or only to a minor extent, participate in the risks and rewards of the vehicle, which reside with the limited partners. In most instances, limited partnerships are not consolidated under IFRS because UBS's legal and contractual rights and obligations indicate that UBS does not have the power to govern the financial and operating policies of these entities and concurrently do not have the objective of obtaining benefits from its activities through such power.

SPEs used for securitization. SPEs for securitization are created when UBS has assets (for example, a portfolio of loans) which it sells to an SPE, and the SPE in turn sells interests in the assets as securities to investors. Consolidation of these SPEs depends mainly on whether UBS retains the majority of the benefits or risks of the assets in the SPE.

UBS does not consolidate SPEs for securitization if it has no control over the assets and no longer retain any significant ex­posure (for gain or loss) to the income or investment returns on the assets sold to the SPE or the proceeds of their liquidation. This type of SPE is a bankruptcy remote entity - if UBS were to go bankrupt the holders of the securities would clearly be owners of the asset, while if the SPE were to go bankrupt the securities holders would have no recourse to UBS.

SPEs for credit protection are set up to allow UBS to sell the credit risk on portfolios, which may or may not be held by UBS, to investors. They exist primarily to allow UBS to have a single counterparty (the SPE), which sells credit protection to it. The SPE in turn has investors who provide it with capital and participate in the risks and rewards of the credit events that it insures. UBS generally consolidates SPEs used for credit protection.

Equity compensation

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.

Deferred taxes

Deferred tax assets arise from a variety of sources, the most significant being: a) tax losses that can be carried forward to be utilized against profits in future years; and b) expenses recognized in the books but disallowed in the tax return until the associated cash flow occurs.

UBS records a valuation allowance to reduce its deferred tax assets to the amount which can be recognized in line with the relevant accounting standards. The level of deferred tax asset recognition is influenced by management's assessment of UBS's future profitability profile. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed circumstances. In a situation where recent losses have been incurred, the relevant accounting standards require convincing evidence that there will be sufficient future profitability.

At 31 December 2008, recognized deferred tax assets amount to CHF 8.9 billion. Recognized deferred tax assets include an amount related to tax loss carry-forwards of CHF 8.1 billion, mainly relating to tax losses incurred in UBS AG, Switzerland, that can be utilized to offset taxable income in Switzerland in future years. The losses mainly resulted from the write-down of investments in US subsi­diaries. At 31 December 2007, recognized deferred tax assets amounted to CHF 3.2 billion.

Swiss tax losses can be carried forward for seven years. The deferred tax assets recognized at 31 December 2008 have been based on future profitability assumptions over a five year horizon. The level of assets recognized may, however, need to be adjusted in the future in the event of changes to those profitability assumptions. Refer to Note 22 for further details.