Accounting Rate of Return - Explained
What is an Accounting Rate of Return?
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What is an Accounting Rate of Return (ARR)?
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.
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What is the 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 bakers 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.