The Accounting Rate of Return shortly referred to as ARR, is the percentage of average accounting profit earned from an investment in comparison with the average accounting value of an investment over the period.
What Does Accounting Rate of Return Mean?
What is the definition of the accounting rate of return? ARR is an important calculation because it helps investors analyze the risk involved in making an investment and decided whether the earnings are high enough to accept the risk level.
Most people and companies have some types of investments. Whether the investments are short-term CDs or long-term retirement plans, investments play a big role in Americans’ lives. The only way to tell whether an investment is worthwhile or not is to measure the return or amount of money the investment has made and is expected to make in the future. To do this we must know how to calculate the accounting rate of return.
How Is Accounting Rate of Return Used?
Companies use the accounting rate of return to assess various capital budgeting decisions or investment opportunities. It is a method of accounting profits by taking the initial valuation of an investment and adjusting for the cash outflows associated with owning the asset.
Before a business commits to a particular capital investment, it may use ARR to determine the potential cash flow that an asset or investment can bring in. They also may use this calculation to determine if an investment they have already made was a wise choice.
How to calculate ARR
Doing an ARR calculation is relatively simple. Here’s what you need to do to calculate ARR:
- First off, work out the annual net profit of your investment. This will be the revenue remaining, after all, operating expenses, taxes, and interest associated with implementing the investment or project have been deducted.
- If the investment is a fixed asset, such as property, you’ll need to work out the depreciation expense.
- Then, to arrive at the final figure for annual net profit, simply subtract the depreciation expense from your annual revenue figure.
- Finally, you simply divide the annual net profit by the initial cost of the asset or investment. The calculation will show a decimal, so multiply the result by 100 to see the percentage return.
Accounting Rate of Return = (Average Profit / Average Book Value) %
= Total accounting profit over the investment period ÷ Years of Investment
Average Book Value:
= (Initial investment + Scrap Value + Working Capital) ÷ 2
Average Book Value:
= (N.B.V. (year 0) + N.B.V. (year 1) + N.B.V. (year 2) + …) ÷ (Years of Investment + 1)
Problems with the Accounting Rate of Return
There are several serious problems with this concept, which are noted below.
Does Not Apply the Time Value of Money
The measure does not factor in the time value of money. Thus, if there is currently a high market interest rate, the time value of money could completely offset any profit reported by a project – but the accounting rate of return does incorporate this factor, so it clearly overstates the profitability of proposed projects.
Does Not Factor in Impacts on the Constraint
The measure does not factor in whether or not the capital project under consideration has any impact on the throughput of a company’s operations.
Does Not Account for Interrelated Systems
The measure does not account for the fact that a company tends to operate as an interrelated system, and so capital expenditures should really be examined in terms of their impact on the entire system, not on a stand-alone basis.
Does Not Compare Projects
The measure is not adequate for comparing one project to another, since there are many other factors than the rate of return that should be considered, not all of which can be expressed quantitatively.
Does Not Show Return on Cash Flows
The measure includes all non-cash expenses, such as depreciation and amortization, and so does not reveal the return on actual cash flows experienced by a business.
Does Not Account for Time-Based Risk
There is no consideration of the increased risk in the variability of forecasts that arises over a long period of time.
What are the advantages and disadvantages of using the accounting rate of return?
|1||This is a simple method that uses the profit from investment to quickly know the return.||This method is based on accounting profits only and does not consider the cash inflows, taxes, etc.|
|2||It is easy to calculate and understand the payback pattern over the economic life of the project||This method cannot be used where the investment in a project is made at different times or in parts.|
|3||It shows the profitability of an investment and helps to measure the current performance of the project||One of the main disadvantages of this method is that it ignores the time factor. The time value of money is an important factor in deciding the viability of investment|
|4||This method enables the comparison of various projects of competitive nature||When different projects are compared, this method does not consider the life period of various investments and hence it may not produce the accurate results as required.|
|5||Small-time investors would be using this method more frequently for appraising their investment decision||This method ignores the external factors and also the results are different if the same project is analyzed using the return on investment method. Hence it is not suitable for huge and long-term projects|