Glossary term
Accounting Rate of Return
Accounting rate of return measures average accounting profit from an investment as a percentage of the average investment amount.
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What Is Accounting Rate of Return?
Accounting rate of return, or ARR, measures average accounting profit from an investment as a percentage of the average investment amount. It is a simple capital-budgeting metric used to compare projects based on reported profit rather than discounted cash flow.
ARR is easy to calculate and explain, but it has an important limitation: it uses accounting profit, not actual cash flow, and it does not directly account for the time value of money.
Key Takeaways
- Accounting rate of return compares average accounting profit with average investment.
- It is often used as a simple project-screening or capital-budgeting metric.
- ARR uses accounting income, so depreciation and other noncash charges affect the result.
- It does not discount future cash flows or measure payback timing.
- ARR should usually be read alongside cash-flow metrics such as net present value, internal rate of return, or payback period.
Accounting Rate of Return Formula
The common version of ARR is:
Average annual accounting profit is the expected annual profit after accounting expenses such as depreciation. Average investment is often calculated as the average book value of the investment over its useful life, though companies may define the denominator differently in internal analyses.
For example, suppose a machine is expected to generate average annual accounting profit of $24,000 and the average investment is $200,000. ARR is 12%. That means the project is expected to earn accounting profit equal to 12% of the average investment each year, before considering whether the cash arrives early or late.
How ARR Works in Project Decisions
A company may set a minimum accounting rate of return for projects. If a proposed investment is expected to produce an ARR above that hurdle, it may move forward for deeper review. If the ARR is below the hurdle, the project may be rejected or redesigned.
The metric is most useful when management wants a quick profitability screen based on accounting results. It can also be useful when a project will be judged internally by reported earnings rather than cash flow alone.
What ARR Can Miss
ARR can make two projects look similar even when their cash-flow timing is very different. A project that produces profit quickly is usually more valuable than one that produces the same accounting profit much later, all else equal. ARR does not capture that timing difference.
The metric can also be sensitive to depreciation method, useful-life assumptions, salvage value, and how average investment is defined. A project can show an attractive ARR while still tying up too much cash, carrying high risk, or failing a discounted-cash-flow test.
ARR Versus Cash-Flow Metrics
Metric | Focus | Main limitation |
|---|---|---|
Accounting rate of return | Average accounting profit relative to average investment. | Ignores time value of money and cash-flow timing. |
Net present value | Discounted value of expected cash flows. | Requires a discount rate and cash-flow assumptions. |
Payback period | How quickly the investment is recovered. | Can ignore value after payback and profitability. |
The Bottom Line
Accounting rate of return is a simple profitability measure for projects and investments. It can help screen opportunities, but it should not be the only decision tool because accounting profit is not the same as cash flow or economic value.