What is Cost-Benefit Principle?
Cost Benefit Principle is an accouting concept that states that the benefits of an accounting system that help produce financial reports and statements should always outweight its associated costs.
Example 1 – Forensic Accounting
Let us consider an instance from the field of forensic accounting. 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 2 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 2 full years of theft and also traces certain transactions which are dated to as long as 5 years. There is a realization for the owner that the accountant would be unable to repay the stolen amount of money in the past 5 years but if sufficient evidence is available for 2 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 prior to 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 statements in March for its previous year. The statement highlights an error in the previous 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.
Important Points to Note
- The controller of the company requiring the benefits 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.
- The entities which have set the standards require judging the level of information they expect firms to report in their financial statements. This is done so that requirements do not cause an excessive amount of work for the business.
The Cost-Benefit principle focuses on the benefits which the receiver should get from a given activity. It attempts to measure the value one can extract after paying a sum of money. Below are some of the critical pointers to be kept in mind:
- An individual/firm/society should take action only if excessive benefits from taking an action are at least as much as the extra costs
- People generally are under the impression as if they are comparing the relevant costs and benefits.
- Critics of this approach often object that people don’t really compute costs and associated benefits when taking a decision.
This 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 important notes. You can learn more about from the following articles –