Accounting Rate of Return Method

The accounting rate of return (ARR), also known as the return on investment (ROI), uses accounting information, as revealed by financial statements, to measure the profitability of an investment. The accounting rate of return is found out by dividing the average after-tax profit by the average investment. The average investment would be equal to half of the original investment if it is depreciated constantly. Alternatively, it can be found out dividing the total of the investment’s book values after depreciation by the life of the project. The accounting rate of return, thus, is an average rate and can be determined by the following equation:

 ARR  =         Average annual accounting profit / Initial investment

Where the profit is calculated as the profit related to the project using all accruals and non-cash expenses required under the GAAP or IFRS frameworks (thus, it includes the costs of depreciation and amortization). If the project involves cost reduction instead of earning a profit, then the numerator is the amount of cost savings generated by the project. In essence, then, profit is calculated using the accrual basis of accounting, not the cash basis. The initial investment is calculated as the fixed asset investment plus any change in working capital caused by the investment.

Acceptance Rule

As an accept-or-reject criterion, this method will accept all those projects whose ARR is higher than the minimum rate established by management and reject those projects which have ARR less than the minimum rate. This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Evaluation of ARR Method

The ARR method may claim some merits.

• It is very simple to understand and use.
• The ARR can be readily calculated from the accounting data; unlike the NPV and IRR rules, no adjustments are required to arrive at cash flows of the project,
• The ARR rule incorporates the entire stream of income in calculating. the project’s profitability.

The ARR is a method commonly understood by accountants, and frequently used as a performance measure.

Shortcomings

As a decision criterion, however, it has serious shortcoming.

• It uses accounting profits, not cash flows, in appraising the projects. Accounting profits are based on arbitrary assumptions and choices and also include non-cash items. It is, therefore, inappropriate to rely on them for measuring the acceptability of the investment projects.
• The averaging of income ignores the time value of money. In fact, this procedure gives more weightage to the distant receipts.
• The firm employing the ARR rule uses an arbitrary cut-off yardstick. Generally, the yardstick is the firm’s current return on its assets (book-value). Because of this, the growth companies earning very high rates on their existing assets may reject profitable projects (i.e., with positive NPV s) and the less profitable companies may accept bad projects (i.e., with negative NPV s).

The ARR method continues to be used as a performance evaluation and control mea-sure. But its use as an investment criterion is certainly undesirable. It may lead to unprofitable allocation of capital.