The Accounting Rate of Return (ARR), also known as the Average Accounting Return (AAR), is a financial metric used to evaluate the profitability of an investment project. Unlike the Internal Rate of Return (IRR) or Net Present Value (NPV), ARR is a simple accounting-based measure that focuses on the average accounting profit generated by an investment over its lifespan.

Calculation:

The formula for calculating the Accounting Rate of Return is as follows:

$\text{ARR}=\frac{\text{Average Accounting Profit}}{\text{Average Investment}}\times 100$

ARR=Average InvestmentAverage Accounting Profit​×100

Where:

• Average Accounting Profit is the average annual accounting profit over the project’s lifespan. It is often calculated as the total accounting profit divided by the number of years.
• Average Investment is the average investment cost over the project’s lifespan. It is typically calculated as the sum of the initial investment and the salvage value (if any) divided by two.

Interpretation:

The ARR is expressed as a percentage. The decision rule for ARR is generally as follows:

• Decision Rule: If the ARR is equal to or greater than the company’s required rate of return or a predetermined target rate of return, the project may be deemed acceptable. If the ARR is less than the required rate of return, the project may be rejected.

Key Considerations:

1. Simple Calculation:
   • ARR is easy to calculate and does not require complicated discounting of cash flows.
2. Accounting Focus:
   • ARR is based on accounting measures, specifically accounting profits and investment costs.
3. Profitability Assessment:
   • ARR provides a measure of the average annual accounting profitability of an investment.
4. Use of Accounting Profits:
   • Unlike other financial metrics, ARR uses accounting profits (which include non-cash items) instead of cash flows.
5. Discount Rate Absence:
   • ARR does not explicitly consider the time value of money, discount rates, or the present value of cash flows.
6. Simplicity vs. Accuracy:
   • While ARR is simple to calculate, its simplicity comes at the expense of not capturing the time value of money and potentially leading to inaccurate results.
7. Comparison Challenges:
   • Comparing projects with different lifespans or cash flow patterns may be challenging using ARR.
8. Focus on Accounting Metrics:
   • ARR may not align with financial goals that prioritize metrics such as shareholder value or wealth maximization.
9. Risk Consideration:
   • ARR does not explicitly account for risk factors associated with an investment.

The Accounting Rate of Return is a straightforward method to assess the profitability of an investment project, especially when a company’s focus is on accounting metrics. However, it has limitations, particularly in its simplicity and lack of consideration for the time value of money. For more comprehensive financial analysis, companies often use other metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR) alongside ARR.