Accounting (average) Rate of ReturnExplained and Defined with Formula, Examples, and Advantages or Disadvantages
What Is the Accounting Rate of Return (ARR)?
The accounting rate of return, also known as the simple rate of return, measures the profitability rate of an investment by comparing the average annual net income to the original cost of the investment.
With this accounting technique, the company may monitor the performance rate of the invested capital.
In the computation of the ARR, cash flows and the time value of money – which are important factors in maintaining a business – are not considered.
The ARR is computed by computing the average revenue of an asset and then dividing that by the initial investment of the company which will provide information on the return or the ratio to be derived over an asset’s lifetime.
Understanding the Accounting Rate of Return
One important technique to use in capital budgeting is to compute the accounting rate of return to quickly determine the profitability of a project.
ARR is useful if the company currently holds multiple projects.
In this technique, the company may be able to derive the profitability rate of each project by using only the ARR formula and decide whether to acquire or invest.
ARR considers all operational expenses (cash and non-cash expenses).
A perfect example of a non-cash expense is the depreciation of a non-current asset.
The function of depreciation in accounting for the total expense is to calculate the amount to be recognized for each fixed asset.
The computation of depreciation expense will be based on the useful life of the related asset.
The Formula for calculating ARR:
How to Calculate the Accounting Rate of Return (ARR)
- Compute the investment’s Annual Net Income by deducting all related expenses both cash & non-cash that are essential for the implementation of the project or investment.
- Subtract non-cash expenses such as depreciation for fixed asset investments from the net revenue.
- Divide the annual net income by the cost of initial investment, then multiply by 100 to arrive at a whole number for the percentage.
Example of Accounting Rate of Return
The management wants to consider a proposed project and expects to generate a return in three years.
The company will be able to compute the ARR with the given information:
Initial Investment: $200,000
Expected revenue per year: $50,000
Time frame: 3 years
Accounting Rate of Return (ARR) = $50,000 / $200,000
ARR = 0.25 or 25% (0.25 x 100)
Accounting Rate of Return vs. Required Rate of Return
ARR gives the management the profitable percentage from the initial investment using annual net income.
RRR or Required Rate of Return is another capital budgeting technique that helps the investor decide whether to invest or not in a certain project considering the compensation they receive with a given risk level.
A minimum return on their capital will be calculated, after which, it is at the investor’s discretion to push through in investing in a project.
Investors have different risk tolerance and perspectives on the investing process.
Some investors are well aware that the higher the risk, the higher the return on the investment, and the.
With the help of ARR and RRR, management can utilize the best strategy to determine whether an investment is worth their while.
Advantages and Disadvantages of the Accounting Rate of Return (ARR)
ARR is a straightforward calculation and is not complicated.
All related expenses will be straightforwardly deducted from the total revenue to arrive at the annual net income.
Decision-making will also be straightforward for the management because they just have to compare the ARR to the minimum required return.
The minimum required return will serve as a threshold if the project will be accepted or not.
For example, the minimum required return must be at a rate of 15%, and the computed ARR is only at 10%.
It clearly shows that the ARR did not meet the benchmark and so the management can decide not to go ahead with the investment.
ARR has some limitations too, one of which is not considering the time value of money.
Time value of money has a big role in determining a more accurate amount of profit, grounded on the idea that the value of money tomorrow will not be the same as the value of money today due to its earning capacity.
Under ARR, the risk of investing in long-term investments is not considered along with the uncertainties that come with such a timeframe.
The timing of cash flows is also key in every business decision that investors make, which is not available when computing the ARR.
For example, an initial investment of $200,000 which will yield a return in a 5-year period will provide information to the investor that ARR is 25%.
The ARR may tell an investor that there is a return but it will not say when the investor will actually take advantage of the positive cash flows.
- Determine the annual profitability rate of return of the invested capital.
- Easily compared to the minimum rate of return
- Straight forward calculation
- A profit-oriented calculation
- The time value of money is not considered
- Does not consider the risk brought by long-term investments
- Does not consider the timing of cash flow
How Does Depreciation Affect the Accounting Rate of Return?
Depreciation is an addition to total recognized expenses. The higher the expense, the lower the profit would be.
This low amount of profit will directly result in a lower rate of return.
What Are the Decision Rules for Accounting Rate of Return?
The basis of the decision if a company should invest in a proposed project would be that the ARR must be greater than or equal to the cost of capital.
What is the Difference Between ARR and IRR?
The main difference between ARR and IRR is that IRR satisfies the time value of money, while ARR does not.
To compute the profitability rate on the invested capital of a certain project, IRR uses a discounted rate.
The Bottom Line
ARR would give the management a profitability rate of return on an initially invested capital.
The straightforward calculation of the ARR allows investors to easily determine the profitability of a project or investment.
But since it does not consider the time value of money, the calculated profit rate may not be the true amount that it should be.
Projecting the overall performance of the project may also be difficult to achieve since the cash flow timing is also not considered.
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NYU "The Accounting Rate of Return as a Framework for Analysis" White paper. August 4, 2022
University of Albany "MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES" White paper. August 4, 2022