Cost Benefit Principle

Last Updated :

-

Blog Author :

Sumit Sharma

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

Table Of Contents

arrow

What is the Cost-Benefit Principle?

The 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 outweigh its associated costs.

Table of contents

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 the benefits from taking action are at least as much as the extra costs.

For example, the company's controller should not spend excessive time fine-tuning the financial statements with 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 deciding.

Examples

Cost Benefit Principle

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 this theft is being traced back in the past. The store owner determines the theft dates back to around two years from various sources. 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 traces certain transactions 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 of recovering 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 firm's services 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:

ABC Company issued its financial statements in March for its previous year. The statement highlights an error in last year’s statement estimated at around $250,000. The precise amount of error is unknown and would approximately cost $60 mm to pinpoint the figure. The cost-benefit principle states that ABC co. Need not to find the exact amount, and approximation should be sufficient. A reasonable estimate shall be acceptable since the costs for precisely rectifying the error are very high than the benefits. As they admit to the error, it puts them in a safe position.