What is Cost-Benefit Principle?
Cost Benefit Principle is an accounting concept that states that the benefits of an accounting system that help produce financial reports and statements should always outweight its associated costs.
Understanding Cost Benefit Principle
The Cost-Benefit principle focuses on the benefits which the receiver should get from a given activity. You should take action only if benefits from taking action are at least as much as the extra costs.
For example, the controller of the company should not spend excessive time on fine-tuning the financial statements with the immaterial/irrelevant adjustments. Additionally, information through footnotes should also be avoided since it can give an impression of too much window dressing or perhaps distortion of facts.
Critics of this approach often object that people don’t calculate costs and associated benefits when making a decision.
Example 1 – Forensic Accounting
Let us consider an instance from the field of forensic accountingField Of Forensic AccountingForensic accounting employs a mix of accounting, auditing, and investigative acumen by recording accounting documents, preparing reports, and performing financial analysis for use in legal proceedings. Thus, it provides an accounting analysis from a litigation perspective.. Say an owner of a store finds out that their accountant has been fudging their books of accounts and pocketing the benefits. There is no way to find out how much in the past is this theft being traced back to. From various sources, the store owner determines the theft is dated back to around two years. Thus, he hires the services of an accounting firm to research and produce a report with details of all instances of theft.
The respective accounting firm reports two full years of theft and also traces certain transactions which are dated to as long as five years. There is a realization for the owner that the accountant would be unable to repay the stolen amount of money in the past five years. Still, if sufficient evidence is available for two years, there can be the possibility to recover the same.
Therefore, the owner realized that the cost of the accounting firm unearthing the scam was not in proportion to the benefit. The owner will most likely not get repaid the stolen funds from the last two years, and thus, the services of the firm may not be useful before that time frame.
Example 2 – Internal Process
We can analyze another example of Cost-Benefit Principle associated with the internal processes of a firm:
Let’s say ABC Company issues its financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. in March for its previous year. The statement highlights an error in the last year’s statement estimated at around $250,000. The precise amount of error is not known and would approximately cost $60 mm for pinpointing the figure. The cost-benefit principle states that ABC co. Need not to find the exact amount, and approximation should be sufficient. In this case, a reasonable estimate shall be acceptable since the costs for precisely rectifying the error is very high than the benefits. As they are admitting to the error, it does put them in a safe position.
This article has been a guide to what is Cost-Benefit Principle and its definition. Here we discuss the principles of Cost-Benefit with practical examples and its essential notes. You can learn more about from the following articles –