Accounting rate of return definition
Accounting rate of return, also called simple rate of return or average rate of return, expressed as a percentage, is commonly used in budgeting decisions. It should be noted that while other budgeting methods consider the future cash flow from an investment, this is not the case with ARR. This method is calculated using the expected operating net income which will be earned from future investment. It is used when deciding whether or not a company should make some capital investment. The ARR shows how much money will be earned for every dollar invested in a project. Thus, an ARR of 7% would mean that the investment would generate 7 cents of return for every dollar invested.
What is accounting rate of return?
As a capital budgeting technique, ARR is used for the assessment of future investments and projects. It is estimated on the basis of the average income generated during the life of the investment over the average investment cost.
ARR = Average net income / Average capital costs
Not accounting for the time value of money can be considered a weakness of this budgeting technique. In accordance with the concept of the time value of money, a dollar today is worth more than a dollar in the future. Since ARR is based on accounting profit, it does not recognize that money earned in the future has lower present value. Moreover, ARR does not consider the timing of the income earned. It treats the income the same regardless of whether it is earned in the earlier or later years of the investment’s life.
Decision rule when using ARR for investment decisions
The decision rule for accepting or rejecting a project with ARR can be made when there is only one project or selecting one project from multiple choices. If there is one project, the decision about the acceptance or rejection depends on whether the ARR is in line with the required accounting rate of return expected by managers and investors. When ARR is equal to or higher than the required accounting rate of return, the investment should be approved. A situation could arise whereby one project must be chosen from among a selection of mutually exclusive projects. When this is the case, then the project with the highest ARR should be selected for investment.