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Accounting rate of return

What Is Accounting Rate of Return?

The Accounting Rate of Return (ARR) is a capital budgeting metric used to evaluate the profitability of a potential investment or project. It expresses the average annual accounting profit generated by a project as a percentage of the initial or average investment. As part of a broader category of capital budgeting and investment decisions, ARR provides a straightforward measure that helps companies determine if an investment meets a minimum acceptable rate of return. Unlike some other appraisal methods, the Accounting Rate of Return relies on accounting profit, derived from a company's financial statements, rather than cash flows.

History and Origin

The concept of evaluating investment proposals has existed for a long time, evolving alongside modern financial management. The Accounting Rate of Return is considered one of the traditional or non-discounted methods of investment appraisal. These traditional methods, which also include the Payback Period, gained prominence before the widespread adoption of techniques that explicitly account for the time value of money. The ARR's reliance on accounting figures aligns with historical accounting practices that focused on reported profits rather than the timing of cash flow. This simplicity made it a convenient tool for initial assessments, particularly when more complex discounted cash flow models were less prevalent or computationally intensive17.

Key Takeaways

  • The Accounting Rate of Return measures the average annual accounting profit as a percentage of the initial or average investment.
  • ARR is a traditional capital budgeting technique, providing a simple measure of a project's profitability based on accounting figures.
  • Projects are generally considered acceptable if their ARR meets or exceeds a company's predetermined target rate of return.
  • A key limitation of ARR is its disregard for the time value of money and its reliance on accounting profits, which can be influenced by various accounting treatments.
  • Despite its drawbacks, ARR can be useful for quick, preliminary evaluations and offers a clear return on investment metric.

Formula and Calculation

The formula for the Accounting Rate of Return can be calculated in two common ways: based on the initial investment or the average investment. The more commonly used approach divides the average annual accounting profit by the initial investment.

Method 1: Based on Initial Investment

ARR=Average Annual Accounting ProfitInitial Investment×100%\text{ARR} = \frac{\text{Average Annual Accounting Profit}}{\text{Initial Investment}} \times 100\%

Method 2: Based on Average Investment

ARR=Average Annual Accounting ProfitAverage Investment×100%\text{ARR} = \frac{\text{Average Annual Accounting Profit}}{\text{Average Investment}} \times 100\%

Where:

  • Average Annual Accounting Profit is the total net income from the project over its lifespan divided by the number of years. This profit is calculated after depreciation and taxes.
  • Initial Investment is the total upfront cost required to undertake the project.
  • Average Investment is typically calculated as (Initial Investment + Salvage Value) / 2. If there's no salvage value, it's Initial Investment / 2.

To calculate the average annual accounting profit, you would typically subtract the total estimated costs (including depreciation) from the total estimated revenues over the project's life, and then divide by the project's lifespan.

Interpreting the Accounting Rate of Return

Interpreting the Accounting Rate of Return is straightforward: a higher ARR is generally preferred. When a company evaluates a potential project, the calculated ARR is compared against a predetermined target or "hurdle" rate. If the project's ARR is equal to or greater than the company's required rate of return, the project is considered acceptable, as it is expected to generate at least the desired level of profitability16. Conversely, if the ARR falls below the hurdle rate, the project would typically be rejected.

For instance, an ARR of 15% means that, on average, the project is expected to yield 15 cents in accounting profit for every dollar invested annually. Companies often use ARR to compare mutually exclusive projects, selecting the one with the highest Accounting Rate of Return, assuming other factors are equal. This method provides a clear percentage that can be easily understood and communicated across different departments involved in evaluating investment opportunities.

Hypothetical Example

Consider a manufacturing company, "Alpha Corp.," that is evaluating a new machinery investment costing $500,000. The estimated useful life of the machine is 5 years, with no salvage value. The expected annual revenues generated by the machine are $200,000, and annual operating expenses (excluding depreciation) are $80,000. Alpha Corp uses straight-line depreciation.

  1. Calculate Annual Depreciation:

    Annual Depreciation=Initial CostSalvage ValueUseful Life=$500,000$05 years=$100,000\text{Annual Depreciation} = \frac{\text{Initial Cost} - \text{Salvage Value}}{\text{Useful Life}} = \frac{\$500,000 - \$0}{5 \text{ years}} = \$100,000
  2. Calculate Annual Accounting Profit:

    Annual RevenueAnnual Operating ExpensesAnnual Depreciation=Annual Accounting Profit\text{Annual Revenue} - \text{Annual Operating Expenses} - \text{Annual Depreciation} = \text{Annual Accounting Profit} $200,000$80,000$100,000=$20,000\$200,000 - \$80,000 - \$100,000 = \$20,000

    Since the annual accounting profit is constant, the average annual accounting profit is also $20,000.

  3. Calculate Accounting Rate of Return (using initial investment):

    ARR=Average Annual Accounting ProfitInitial Investment×100%\text{ARR} = \frac{\text{Average Annual Accounting Profit}}{\text{Initial Investment}} \times 100\% ARR=$20,000$500,000×100%=0.04×100%=4%\text{ARR} = \frac{\$20,000}{\$500,000} \times 100\% = 0.04 \times 100\% = 4\%

Based on this calculation, the Accounting Rate of Return for the new machinery is 4%. Alpha Corp would then compare this 4% ARR to its minimum required rate of return for capital projects. If their hurdle rate is, for example, 5%, this project would be rejected. If their hurdle rate is 3%, the project would be accepted. This example highlights how the ARR helps in quantitative investment evaluation.

Practical Applications

The Accounting Rate of Return finds practical application primarily in the initial screening of projects and for businesses that prioritize reported profitability over liquidity or the exact timing of returns. It is often used by smaller businesses or divisions where simpler financial analysis methods are preferred due to resource constraints or a less complex operational environment.

ARR is particularly useful in situations where:

  • Initial Project Screening: It provides a quick and easily understandable percentage that allows managers to get a preliminary sense of a project's profitability before diving into more complex analyses like Net Present Value or Internal Rate of Return.
  • Performance Evaluation: Sometimes, ARR is used to evaluate the past performance of completed projects against their initial projections, linking directly to how profits are reported on a company's income statement.
  • Consistency with Financial Reporting: Since ARR is based on accounting profits, it aligns directly with figures reported in a company's financial statements, which are prepared according to accounting standards like Generally Accepted Accounting Principles (GAAP). These principles, governed in the U.S. by the Financial Accounting Standards Board (FASB) and compiled in the FASB Accounting Standards Codification, dictate how financial information is recognized and presented14, 15. This alignment can make ARR appealing for entities focused on financial statement impacts.

Limitations and Criticisms

Despite its simplicity and ease of calculation, the Accounting Rate of Return has several significant limitations that make it less robust for comprehensive capital budgeting.

  1. Ignores the Time Value of Money: A primary criticism of ARR is that it does not account for the time value of money12, 13. It treats all accounting profits generated over the project's life as having equal value, regardless of when they are received. This means that a dollar earned in year one is considered equivalent to a dollar earned in year five, which is financially unsound given inflation and the potential for reinvestment. This limitation can lead to misleading results, especially for long-term projects or those with irregular profit patterns11.
  2. Relies on Accounting Profits, Not Cash Flows: ARR uses accounting profits, which are subject to various accounting treatments and accrual adjustments, including depreciation methods and revenue recognition policies10. These accounting profits may not accurately reflect the actual cash flow generated by a project, which is crucial for a company's liquidity and ability to meet obligations. Cash flows are generally considered a more reliable measure of a project's true economic viability9.
  3. Does Not Consider Project Risk: The Accounting Rate of Return fails to incorporate the inherent risk associated with an investment7, 8. Different projects carry different levels of risk, which should influence the expected rate of return. By not factoring in risk, ARR might overestimate the attractiveness of high-risk ventures or underestimate lower-risk ones.
  4. Ignores Opportunity Cost of Capital: The method does not explicitly consider the opportunity cost of capital, which is the return that could have been earned by investing in the next best alternative5, 6. This oversight can lead to suboptimal investment decisions.
  5. Does Not Indicate Payback Period: While ARR indicates profitability, it does not provide information about how quickly the initial investment will be recovered, a crucial aspect for businesses concerned with liquidity4.

Given these limitations, financial professionals generally recommend using the Accounting Rate of Return in conjunction with or superseded by discounted cash flow methods for more accurate and comprehensive capital budgeting2, 3.

Accounting Rate of Return vs. Net Present Value

The Accounting Rate of Return (ARR) and Net Present Value (NPV) are both methods used in capital budgeting to evaluate investment projects, but they differ fundamentally in their approach and the information they provide.

FeatureAccounting Rate of Return (ARR)Net Present Value (NPV)
Basis of CalculationUses average annual accounting profit.Uses project's future cash flows.
Time Value of MoneyIgnores the time value of money.Explicitly accounts for the time value of money by discounting future cash flows.
Decision RuleAccept if ARR ≥ target rate; higher ARR is preferred.Accept if NPV > 0; higher NPV is preferred.
MeasurementExpressed as a percentage.Expressed as a monetary value (e.g., dollars).
Reinvestment AssumptionImplicitly assumes profits are reinvested at the ARR.Assumes cash flows are reinvested at the discount rate (cost of capital).
ComplexitySimple to calculate and understand.More complex to calculate, requiring a discount rate.
Goal AlignmentAligns with accounting profitability; may not maximize shareholder value.Directly aligns with maximizing shareholder value by increasing firm wealth.

The primary distinction lies in their treatment of the time value of money and their focus on either accounting profits or cash flows. NPV is generally considered a superior method for evaluating long-term projects because it provides a more accurate assessment of a project's intrinsic value by considering the timing and magnitude of its cash flows. 1ARR, while easy to grasp, can lead to inaccurate investment decisions due to its failure to incorporate the crucial concept that money available today is worth more than the same amount in the future.

FAQs

What is a good Accounting Rate of Return?

A "good" Accounting Rate of Return depends on a company's specific financial goals, industry benchmarks, and its predetermined hurdle rate. If the calculated ARR for a project exceeds the company's minimum acceptable rate of return, it is generally considered a good return for that specific project. Companies establish a minimum acceptable ARR to ensure that new investments contribute sufficiently to their overall profitability.

Is Accounting Rate of Return a traditional or modern method?

The Accounting Rate of Return is considered a traditional (or non-discounted) method of capital budgeting. These methods typically do not account for the time value of money, distinguishing them from modern methods like Net Present Value (NPV) and Internal Rate of Return (IRR).

How does depreciation affect ARR?

Depreciation directly affects the Accounting Rate of Return because it is subtracted when calculating the annual accounting profit. Higher depreciation charges will result in lower accounting profits, which in turn lead to a lower ARR. Different depreciation methods (e.g., straight-line vs. accelerated) can therefore impact the reported ARR for a project even if the underlying cash flows are the same.

Can ARR be negative?

Yes, the Accounting Rate of Return can be negative if the average annual accounting profit generated by a project is a loss (i.e., expenses, including depreciation, exceed revenues). A negative ARR indicates that the project is expected to lose money on an accounting basis over its life and would typically be rejected.