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What is 'Accounting Rate of Return (ARR)'

The accounting rate of return (ARR), also known as the simple or average rate of return, measures the amount of profit, or return, expected on an investment. It divides the average profit by the initial investment to derive the ratio or return that can be expected. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

BREAKING DOWN 'Accounting Rate of Return (ARR)'

The accounting rate of return is a capital budgeting metric useful for a 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 an investment's performance.

Accounting Rate of Return Calculation

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, such as the generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). The profit calculation includes the depreciation and amortization of a project's 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

A project's total profit from the last five years is $50,000. During this time, a total investment of $250,000 was 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 (TVM) and cash flow timing, the accounting rate of return does not provide insights on constraints, bottleneck ramifications, or impacts on company throughput. The accounting rate of return isolates individual projects and may not capture the systematic impact a project may have on the entity. It is also not ideal to use for comparative purposes because financial measurements may not be consistent between projects and other non-financial factors need consideration. Lastly, the accounting rate of return does not consider the increased risk of long-term projects and the increased variability associated with long periods.

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