Uncertainty is a defining feature of the economic environment. Economic agents’ perceptions of risk, together with their willingness and ability to bear it, fundamentally shape decisions, transactions, and market prices. Well-considered decisions should be based on information that helps to highlight existing risks and uncertainties. An important component of the information system of an organization or economy is financial reporting, through which an enterprise conveys information about its financial performance and condition to external users, often identified with its actual and potential claimants. It stands to reason, therefore, that financial reporting should provide a good sense of the impact of those risks and uncertainties on measures of valuation, income, and cash flows.
It is important to reconcile the perspectives of accounting standard setters on the one hand, and prudential authorities on the other, on what information should be reported, and on how it should be portrayed. The final goal is a financial reporting system that is consistent, as far as possible, with sound risk management and management practices and that can serve as a basis for well-informed decisions by outside investors as well as prudential authorities.
Outside investors, be they equity or debt holders, would normally require certain information about the financial performance of a firm so as to guide their decisions. First, they would surely wish to form a view about the firm’s past and current profitability, solvency, and liquidity at a given point in time. Second, they would probably also like to develop a picture of the risk profile of those attributes over time and, hence, of their potential future evolution. Third, they might additionally wish to gain a sense of how reliable or accurate those measures are. Combined, these three elements would provide the raw material to inform views about expected returns properly adjusted for risk and for the inevitable uncertainties that surround measurement. These three types of information correspond to the key categories into which the ideal set can be divided—namely, first movement, risk, and measurement error—and they are equally applicable to financial reporting in an Islamic finance environment.
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