The accounting rate of return (ARR) of an investment project is the profit (usually before interest and tax) expressed as a percentage of the capital invested. It is similar to return on capital employed (ROCE), except that whereas Return on Capital Employed is a measure of financial return for a company or business as a whole, ARR measures the financial return from a specific capital project.
The main feature of ARR is that it is based on accounting profits and the accounting value of assets employed. This means that it will include the following information which would usually be considered irrelevant in other techniques based on cash flows:
- sunk costs (money already spent);
- carrying amounts of assets (net book values);
- depreciation and amortization (non-cash items);
- allocated fixed costs.
Unfortunately, there is no standard definition of accounting rate of return. There are two main definitions:
- Average annual profit as a percentage of the average investment in the project
- Average annual profit as a percentage of the initial investment.
Decision rule for the ARR method
Decisions using ARR are made concerning a target (e.g. WACC, average ARR) set by the company. In other words, a company decides on what it considers to be an acceptable level of return and assesses projects by comparing them to this level.
The decision rule for capital investment appraisal using the ARR method is if the
- Accept a project when its ARR is higher than the target.
- Reject a project when its ARR is less than the target.
The management of the company may be reluctant to accept a project that has an ARR lower than the overall ARR of the company as this will cause the overall ARR of the company to reduce.
Pros and Cons of using the ARR method
The main advantages of the ARR are below:
- It is fairly easy to understand. It uses concepts that are familiar to business managers, such as profits and capital employed.
- It is easy to calculate.
However, there are significant disadvantages to the ARR method.
- It is not linked to the wealth maximization objective. In other words, it does not select projects based on their ability to increase the wealth of the owners of the company.
- We can calculate in different ways so may confuse interpretation.
- It is based on accounting profits (mainly based on accrual and historical cost convention), and not cash flows. However, investments are about investing cash to obtain cash returns. Investment decisions should therefore be based on cash flows, and not accounting profits.
- Since it is based on profits (more subjective) is easy to manipulate and will be different under different accounting policies and estimates.
- We will ignore the time value of money in the ARR method. Using the ARR method, a profit of Rs. 10,000 in Year 1 and Rs. 90,000 in Year 2 is just as valuable as a profit of Rs. 90,000 in Year 1 and Rs. 10,000 in Year 2. However, the timing of profits is significant, because the sooner the cash returns are received, the sooner they can be reinvested to increase returns even more.
- When using the ARR method for investment appraisal, a decision has to be made about what the minimum target ARR should be. Any such minimum target accounting return is a subjective target, with no economic or investment significance.
Frequently Asked Questions
What is the Accounting Rate of Return?
The accounting rate of return (ARR) of an investment project is the profit (usually before interest and tax) expressed as a percentage of the capital invested.
What is the Accounting rate of return on Assets?
A profitability ratio called return on assets shows how much profit a company may make from its assets. Return on assets (ROA) assesses how effectively a company’s management generates revenue from the assets or financial resources that appear on its balance sheet.
What are the disadvantages of accounting rate of return?
The ARR is not based on cash flow like other methods of investment analysis; rather, it is based on profits. Subjective, non-cash factors like the depreciation rate you employ to compute earnings have an impact on it. The timing of profits is another factor that the ARR lacks.
What makes NPV superior to the accounting rate of return?
The NPV approach has an advantage over ARR in the previously mentioned instance since it can take into account different discount rates or different cash flow directions. Since the cash flow from each year may be discounted separately from the others, the NPV technique is more flexible when analyzing specific periods.