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Accounting Rate of Return (ARR) Definition
The accounting rate of return represents the average net income which an asset is expected to generate divided by the average capital loss, expressed as an annual percentage or APR. This formula is used to make budgeting decisions and to evaluate the profitability of investments.
The accounting rate of return reflects the ratio between the increase of wealth and capital investment. Economic profitability is the accounting profitability of fiscal assets. It is important to note, a distinction between economic profitability and the accounting profitability of equity. This distinction is based on the leverage effect of debt.
A Little More on Accounting Rate of Return Formula
The calculation of present value, as well as many other methods, are applied before considering the positives of investment opportunities. The accounting rate of return is often integrated into this process.
There are several formulas to measure the accounting rate of return of an investment. However, for all, the focus to calculate the ratios between net profit generated and the book value remains the same. Average net income and average book value are calculated as averages over a given period of time. Generally, the period of time is the life of the investment. The accounting rate of return formula suggests a project is only profitable if the average of net profit to book value exceeds a predefined level, typically twenty percent.
Example of Calculating Accounting Rate of Return Formula
For example, a baker would like to buy a used oven. A fellow baker offers to buy his for three thousand dollars. Given the age, it would have to be replaced within three years.
The amortization chosen by the baker is linear. This recognizes a loss value of one thousand dollars a year. The average book value over the life expectancy of the oven would be fifteen hundred dollars. Corporate tax on the oven would be thirty-three percent. According to the baker’s projections, the baker expects an average annual turn over of two thousand nine hundred and fifty. According to this, the average net profit would be slightly over four hundred dollars.
The accounting rate of return for this investment would be twenty-six point eight percent. If the baker is satisfied with this accounting rate, he could go ahead with the purchase of the oven.
Issues with Accounting Rate of Return
There are several disadvantages to the accounting rate. The primary one is that it does not take into account the time value of money or inflation. The turnover achieved in the near future is recognized as a turnover in the distant future. This benchmark is unreliable at best. The threshold for accepting investment is arbitrary as each business sets its own threshold. The formula also discounts financial flow generated by the investment.
References for Accounting Rate of Return
Academic Research for Accounting Rate of Return
- The role of the accounting rate of return in financial statement analysis, Brief, R. P., & Lawson, R. A. (1992). Accounting Review, 411-426. Brief and Lawson provide a review of literature relating to the accounting rate of return. From the literature review, the article synthesizes information into a list of practical and analytical significance. These are presented based on the annual rate of return’s relationship with DCF.
- Survey and analysis of capital budgeting methods, Schall, L. D., Sundem, G. L., & Geijsbeek Jr, W. R. (1978). The journal of finance, 33(1), 281-287. The article presents a survey of literature related to capital budgeting. An analysis of the empirical data is completed and presented as practical implications for businesses.
- Rates of return and cash flow profiles: an extension, Gordon, L. A., & Hamer, M. M. (1988). Accounting Review, 514-521. Gordon and Hamer evaluate cash recovery rate as a basis of economic profitability of a firm. The paper builds on prior work by developing a model of CRR-IRR relations. Empirical evidence is used to prove IRR estimates based on concave cash flow are correlated with IRR estimates based on simpler cash flow profiles.
- Working capital and financial management practices in the small firm sector, Peel, M. J., & Wilson, N. (1996). International Small Business Journal, 14(2), 52-68. The paper presents the results of a study on working capital and financial management of small North England firms. The results indicate most sampled firms us quantitative capital budgeting. The firms also us more sophisticated discounted cash flow techniques. These methods have been attributed to reducing stock levels or debtors credit period. The study calls for more theoretical and empirical research in the niche of small business research.
- A longitudinal survey on capital budgeting practices, Pike, R. (1996). Journal of Business Finance & Accounting, 23(1), 79-92. The scholars report the findings of a longitudinal study of capital budgeting practices. The scholars focused on the integration of IS and IT investments and the techniques of capital investment appraisals in the sub-niche. The study concludes with an examination of the extent of appraisal in relation to IT investments, the importance of techniques for these specific investments, and problems arising from the investments.
- Financial appraisal and the IS/IT investment decision making process, Ballantine, J., & Stray, S. (1998). Journal of Information Technology, 13(1), 3-14. Ballantine and Stray explore appraisal techniques specific to IS/IT investments while focusing on capital investment appraisal. The literature review compares IS literature with accounting-based literature, comparing the two perspectives. Issues related to capital investment techniques, the importance of the techniques and the decision-making process are presented.
- A review of recent trends in formal capital budgeting processes, Pike, R. H. (1983). Accounting and business research, 13(51), 201-208. Pike presents a literature review of recent trends in capital budgeting. The study examines the role of accounting rate return in the appraisal of investments and the trends regarding this practice. Implications for including the accounting rate of return in capital investment processes are presented.
- Capital budgeting practices in corporate Canada, Jog, V. M., & Srivastava, A. K. (1995). Financial practice and education, 5(2), 37-43. Jog and Srivastave analyze capital budgeting in corporate Canada. The study analyzes empirical data related to the inclusivity of the accounting rate of return in corporate decisions regarding capital investment appraisals.
- Re-examining project appraisal and control: developing a focus on wealth creation, Akalu, M. M. (2001). International Journal of Project Management, 19(7), 375-383. Akulu reviews the usage of capital investment appraisal techniques based on discounted cash flow. Akulu seeks to ascertain the correlation between these techniques and the value attained. The study reviews traditional investments techniques and the correlating impact on shareholder value. Akulu recommends shareholder value analysis for future investment evaluation.
- Strategic capital investment decision-making: A role for emergent analysis tools?: A study of practice in large UK manufacturing companies, Alkaraan, F., & Northcott, D. (2006). The British Accounting Review, 38(2), 149-173. Alkaraan and Northcott evaluate strategic capital investment decision making through a historical study of large British manufacturing companies. Using empirical data, the research compares traditional investment analysis and emerging strategic analysis techniques. The study found regardless of potential, emerging strategies are rarely employed in practice.
- Accounting returns revisited: Evidence of their usefulness in estimating economic returns, Danielson, M. G., & Press, E. (2003). Review of Accounting Studies, 8(4), 493-530. Danielson and Press evaluate evidence of account rate of return’s usefulness in estimating economic returns. The scholars present a new model that marries the accounting rate of return with the internal rate of return. The analysis illustrates how the conservatism of Generally Accepted Accounting Practices constraints firms. Linking empirical data with economic theory, the article proves the new model while presenting practical implications of the findings.