What is Accounting Rate of Return (ARR)?
The Accounting Rate of Return (ARR) is a financial metric used to measure the profitability of an investment based on accounting information rather than cash flows. It expresses the expected return as a percentage of the initial or average investment.
Definition
The Accounting Rate of Return (ARR) is the average annual accounting profit from an investment divided by the initial or average amount of investment, typically expressed as a percentage.
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Key Takeaways
- Evaluates profitability using accounting profits, not cash flows.
- Simple and easy to compute using data from financial statements.
- Commonly used in capital budgeting and project evaluation.
- Does not consider the time value of money.
- Useful for comparing investments with similar durations or risk levels.
Understanding Accounting Rate of Return (ARR)
ARR is a straightforward performance metric used by management to assess investment attractiveness. It relies on accounting profit, which includes depreciation and excludes non-cash items. This distinguishes it from cash-based methods like Net Present Value (NPV) or Internal Rate of Return (IRR).
While ARR is easy to calculate, it may be less accurate for projects with uneven cash flows or different lifespans. Companies often use ARR as a screening tool before applying more sophisticated discounted cash flow analyses.
Formula (If Applicable)
ARR = (Average Annual Accounting Profit / Initial Investment) × 100
or
ARR = (Average Annual Accounting Profit / Average Investment) × 100
Example:
If an investment costs $500,000 and generates $75,000 in average annual accounting profit:
ARR = (75,000 / 500,000) × 100 = 15%.
Real-World Example
A company invests $1 million in new equipment expected to last 10 years, generating annual accounting profits of $150,000. The ARR = (150,000 / 1,000,000) × 100 = 15%. Management compares this to its target ARR (e.g., 12%) to determine approval.
Many firms use ARR alongside payback period and NPV analyses for a balanced investment appraisal.
Importance in Business or Economics
ARR is vital for capital budgeting decisions, helping management:
- Evaluate expected accounting profitability of projects.
- Compare investment opportunities under uniform reporting standards.
- Support budget allocation and performance benchmarking.
Economically, ARR contributes to internal rate-based evaluation within organizations where non-financial managers prefer simpler, accounting-based metrics.
Types or Variations
- Initial Investment Method: Uses the total project cost as the denominator.
- Average Investment Method: Uses the average book value of investment.
- Pre-Tax ARR: Based on profits before tax.
- Post-Tax ARR: Reflects net profitability after tax effects.
Related Terms
- Internal Rate of Return (IRR)
- Net Present Value (NPV)
- Return on Investment (ROI)
- Payback Period
- Depreciation Expense
Sources and Further Reading
- FASB – Accounting Standards on Asset Depreciation and Investment Reporting.
- Investopedia – Accounting Rate of Return (ARR).
- Corporate Finance Institute (CFI) – Capital Budgeting Techniques.
- IFRS Foundation – IAS 16: Property, Plant, and Equipment.
Quick Reference
- Formula: ARR = (Average Accounting Profit / Investment) × 100.
- Focus: Profitability from accounting data.
- Limitation: Ignores time value of money.
- Common Use: Project screening and performance evaluation.
- Decision Rule: Accept if ARR ≥ required rate of return.
Frequently Asked Questions (FAQs)
What’s the difference between ARR and IRR?
ARR uses accounting profit; IRR uses discounted cash flows and accounts for time value of money.
Why do companies use ARR?
Because it’s simple, based on existing accounting data, and easy to communicate across departments.
Is ARR reliable for long-term investments?
Not fully — it ignores timing and risk of cash flows, so it should complement NPV or IRR analyses.
Does ARR consider depreciation?
Yes, because it’s based on accounting profit, which includes depreciation expense.
