What is Uncertainty?
Uncertainty simply means the lack of certainty or sureness of an event. In accounting, uncertainty refers to the inability to foretell consequences or outcomes because there is a lack of knowledge or bases on which to make any predictions.
The term is often widely used in financial accounting, especially because there are many events that are beyond a company’s control that can greatly affect its transactions. Since it is much harder to make financial decisions during times of uncertainty, many company owners refrain from making one to avoid creating problems.
Comparing Risk and Uncertainty
It is not uncommon to find people who get confused between risk and uncertainty. Although some organizations and experts in the financial world find the two terms interchangeable, the concepts actually are different in the following ways:
- Risk is simpler and easier to manage, especially if proper measures are observed. Uncertainty, as commonly known, is about not knowing future events.
- According to American economist Frank Knight, risk is something that can be measured and quantified, and that the taker can take steps to protect himself from. Uncertainty, on the other hand, does not allow taking such steps since no one can exactly foretell future events.
- A risk may be taken or not, while uncertainty is a circumstance that must be faced by business owners and people in the financial world.
- Taking a risk may result in either a gain or a loss because the probable outcomes are known, while uncertainty comes with unknown probabilities.
Example of Risk and Uncertainty
To illustrate the differences between risk and uncertainty, let us tackle the following example.
Let’s say a gardener puts two different plants in two pots and labels them A and B. Now, he calls an apprentice gardener and tells him the things to do to plant A, which include putting it under the sun for several hours a day every day, watering it two times a day, and weeding it every other day. On the other hand, he says not to do any of these things to the other plant but will give it organic fertilizer to help it grow.
He then asks which of the two will probably live and thrive. Of course, given the background and the knowledge of the things the gardener will do, the apprentice can weigh which of the two plants will most probably grow. This is an example of risk.
Now, what if the gardener says he will do nothing to either of the plants and asks the apprentice which he thinks will most likely survive? The answer would be uncertain because of the lack of sufficient information and the inability to predict the outcome.
Uncertainty and Investing
Uncertainty is one concept in finance and accounting that should be deeply understood. Business owners, as well as investors, want to access credible and honest financial statements during times of uncertainty.
Through generally accepted accounting principles, including those that are from the Financial Accounting Standards Board, there are now processes that can be used to identify, record, and disclose uncertainty. Using accounting principles consistently makes it possible to compare financial records from various periods.
How to Turn Uncertainty into an Advantage
The only thing certain thing about uncertainty is that it can happen anytime, and when it does, no company is exempt from feeling its effects. Therefore, the most effective thing to do is to prepare for it and turn it into an advantage. Here’s how:
1. Forecasting is essential
Companies who rely on annual budgets are finding themselves in shallow waters nowadays because the figures may no longer be applicable even before a specific financial year is over. This is why forecasting and updating plans regularly are important.
2. Shift to automation
Manual collection of data takes up more time than actually analyzing it, which is why it is often too late when problems are identified. Business organizations should shift to automation because it cuts the time needed for data collection and analysis.
3. Efficient reporting of finances
Automation also contributes to achieving financial reports that are efficient and accurate.
4. Self-service is key
Stakeholders are an important component of an organization, which is why providing self-service apps is helpful. For example, users can use a specific app that lets them open their accounts and evaluate the data by themselves. This not only gives them the freedom to do so anytime it is convenient for them but it also frees up work for the organization’s IT team, letting them concentrate on more important processes.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
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