Accounting Rate of Return

Average Accounting Return is also known as Simple Rate of Return. ARR reveals the net profit of an investment in relation to its cost. It calculates the trend or, in other words, the average annual profit or return on an investment in relation to the cost of that investment.

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    ARR Formula

    The formula for ARR is as follows:

    ARR = Average Annual Profit/Initial Investment × 100

    Accounting Rate of Return Meaning

    ARR is a measure of the profitability of an investment or project. Since it is in percentage form, it can be easily compared with other project or various proposals for investment.

    Advantages of Accounting Rate of Return

    Easy Computation: The calculation of ARR is relatively simple and comprehensible because it only needs some basic financial information.

    Relative Measure: It provides a return in the form of a percentage. Thus, comparisons between projects or investments can be made quite easily.

    Useful for Projects with Non-Cash Flow Benefits: Unlike cash flow-based measures, ARR is based on accounting profit. Hence, you can also apply to projects that offer non-cash benefits.

    Accounting Rate of Return Disadvantages

    Ignores Time Value of Money: ARR does not consider the time value of money. Because of this fact, it can lead to faulty investment decisions.

    No Consideration of Cash Flow: Because it makes use of accounting instead of cash flow, the ARR may not correctly indicate the proper financial position of an investment.

    Dependent on Accounting Measures: The result may change with different accounting policies and different estimation techniques used, which raises questions regarding comparability.

    Example of Accounting Rate of Return

    Company A invests $100,000 in a project that promises to return profits of $20,000 annually for 5 years.

    ARR = 20,000/$100,000 × 100 = 20%

    Here, the ARR is 20% because for every dollar invested in the project, it means 20 cents of profit are generated every year.

    Conclusion

    ARR is an estimate that gives the evaluator a general feeling of an investment’s profitability within a short time based on the accounting profits. Although it presents ease of calculation and a concise percentage return, it has to be weighed against its shortcomings, most relating to the time value of money and considerations about cash flow.

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