How is the Accounting Rate of Return Calculated

Definition of Accounting Rate Of Return

The accounting rate of return is defined as a financial ratio used to analyze a financial investment’s profitability. It is a ratio of the average profit (also called average income) earned from an investment to the average net value of the investment (also called average book value). It focuses on financial statements instead of cash flows.

Features or Characteristics of Accounting Rate of Return

The features of this method are listed below:

  1. This method considers the net profit, i.e., the earnings after depreciation and tax.
  2. The average profit is defined as the sum of the net profits divided by the number of investment years.
  3. The average book value is defined as the sum of the book value of initial investment and book value of investments divided by two or can be calculated as the average of the net booking value over the years of investment.
  4. The method measures the firm’s current growth and, therefore, can be used as criteria to decide whether one should invest or not.
  5. This method serves the interest of the shareholders as they are interested in the rate of returns.
  6. The method helps in comparing the recent project and the cost-reducing project. The projects that have an Accounting Rate of Return higher than the required return can be accepted.
  7. The high Accounting Rate of Return indicates better is investment.

How to Calculate Accounting Rate of Return

 Accounting Rate of Return is used as a metric for quick calculation of the profitability of an investment. It is generally used to check the performance of the company. It can help the investors choose which project to invest in to earn the required rate of return.

Implementations: The following steps are involved in calculations of Accounting Rate of Return Calculate the total revenue and expenses of the project/investment.

  • Identify the net profit, i.e., net income after interest and depreciation, for each year over the investment period.
  • Calculate the average net profit.
  • Identify the initial investment and the value of the investment in the last year.
  • Calculate the average book value.
  • Find the Accounting Rate of Return.

Pros and Cons of Average Accounting Rate of Return

  • Pros of  accounting rate of return ARR

    • The Accounting Rate of Return is the only method that takes into account the net profit while finding the rate of return
    • It is straightforward and easy to calculate.
    • Accounting Rate of Return is based on the financial statements readily available and can be understood.
  • Cons accounting rate of return ARR

    • Accounting Rate of Return does not take into consideration the cash flows.
    • Accounting Rate of Return neither accounts for the time value of money nor the future cash flows.
    • The Accounting Rate of Return is not reliable as there is no standard threshold. All the businesses set their limit for accepting the investments.
    • It is not adjusted to the long-term risks involved in an investment.

Conclusion of Accounting Rate of Return on Initial Investment

Despite the limitations, the Accounting Rate of Return continues to be the most used method to calculate the rate of return of an investment. This method is widely used for the appraisal of investment proposals as it uses the concept of net earnings and is easy to comprehend.