What is the 'Accounting Rate of Return - ARR'
The accounting rate of return (ARR) is the amount of profit, or return, an individual can expect based on an investment made. Accounting rate of return divides the average profit by the initial investment to get the ratio or return that can be expected. ARR does not consider the time value of money, which means that returns taken in during later years may be worth less than those taken in now, and does not consider cash flows, which can be an integral part of maintaining a business.
BREAKING DOWN 'Accounting Rate of Return - ARR'Accounting rate of return is also called the simple rate of return and is a metric useful in the quick calculation of a company’s profitability. ARR is used mainly as a general comparison between multiple projects as it is a very basic look at how a project is doing.
Calculation of Accounting Rate of Return
The accounting rate of return is calculated by dividing the average annual accounting profit by the initial investment of the project. The profit is calculated using the appropriate accounting framework including generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). The profit calculation includes depreciation and amortization of project assets. The initial investment is the fixed asset investment plus any changes to working capital due to the asset. If the project spans multiple years, an average of total revenue per year or investment per year is used.
Accounting Rate of Return Example
The total profit from a project over the past five years is $50,000. During this span, a total investment of $250,000 has been made. The average annual profit is $10,000 ($50,000/5 years) and the average annual investment is $50,000 ($250,000/5 years). Therefore, the accounting rate of return is 20% ($10,000/$50,000).
Accounting Rate of Return Drawbacks
In addition to the lack of consideration given to the time value of money as well as cash flow timing, accounting rate of return does not provide any insight as to constraints, bottleneck ramifications or impacts on company throughput. Accounting rate of return isolates individual projects and may not capture the systematic impact a project may have on the entire entity – both positively and negatively. Accounting rate of return is not ideal to use for comparative purposes because financial measurements may not be consistent between projects and other non-financial factors need consideration. Finally, accounting rate of return does not consider the increased risk of long-term projects and the increased variability associated with long periods of time.