What is an Accounting Rate of Return (ARR)?

Accounting Rate of Return (ARR): It measures average return on investment in terms of income rather than cash flows.It is also known as return on investment or return on capital employed. Higher the ARR of a project better for the investment. It does not consider time value of money.

Advantages of Accounting Rate of Return:

·        It is very simple and easy to calculate.

·        It needs financial statement for computing ARR.

·        It gives rough idea to know that is this investment is good for business or not?. Company cannot depend on ARR for taking a decision.

Disadvantages of Accounting Rate of Return:

·        It does not include time value of money concept.

·        It does not show accurate value of investment because it is just based on averages of cash flows.

Formula for Accounting Rate of Return (ARR):

Accounting Rate of Return (ARR) = Average net annual income/ Average Investment

                                                          OR

Accounting Rate of Return (ARR) = Average net annual income/ Original Investment

Average net annual income = (total income – operating expense (including depreciation, tax etc))/ No. of years

Average Investment = Net working capital+Salvage value+ 1/2(Initial investment - salvage value)

Example: In project A the initial investment is Rs.2, 00,000 for 5 years. Incomes in five years are as follows –

·         Rs. 50,000,

·          Rs.55, 000,

·         Rs.60, 000,

·          Rs.70, 000 and

·         Rs.82,000

.Find out the accounting rate of return?

Particular	1st year	2nd year	3rd year	4th year	5th year
Profit	50,000	55,000	60,000	70,000,	82,000
*Depreciation	(40,000)	(40,000)	(40,000)	(40,000)	(40,000)
Net Profit/ Income	10,000	15,000	20,000	30,000	42,000

*Average depreciation = (Initial investment-Salvage Value)/Useful life in years

Net total income =Rs. (10,000 +15, 000 + 20, 0000 + 30, 000 + 42, 000) = Rs. 1, 17, 000

Average net annual income= (total income – operating expense (including depreciation, tax etc))/No. of years

= 1,17,000/5

=Rs.23,400

Average Investment = Net working capital+salvage value +1/2 (Initial investment - salvage value)

=0+0+1/2 (2,00,000-0)

=1,00,000

Accounting Rate of Return (ARR) = Average net annual income/ Average Investment

=23,400/1,00,000

=0.47*100

=23%

OR

Accounting Rate of Return (ARR) = Average net annual income/ Original Investment

=23,400/2,00,000

=11.7%

Example: There are three investment project A,B and C the cost of investment are Rs.5,00,000,Rs 5,00,000 and Rs.7,00,000 respectively for 4 years.In below table 4 years profits and other information are provided:

Particular	1st year	2nd year	3rd year	4th year
Project A( profit after depreciation and tax)	30,000	33,000	22,000	46,000
Project B ( profit after depreciation and tax)	29,000	42,000	15,000	74,000
Project C  ( profit after depreciation and tax)	20,000	36,000	30,000	30,000

Other information is:

• Salvage value of project A is Rs.15, 000.

• Depreciation has been charged on straight line method.

Particular	Project A (Rs.)	Project B (Rs.)	Project C (Rs.)
Original investment	(5,00,000)	(5,00,000)	(7,00,000)
Income/Profit after depreciation and tax	1,31,000	1,60,000	1,16,000
*Average net annual income	32,750	40,000	29,000
*Average investment	2,57,500	2,50,000	3,50,000
*Accounting Rate of Return (ARR)	12.7%	16%	8.2%

*Average net annual income= (total income – operating expense (including depreciation, tax etc))/No. of years

*Average Investment = Net working capital+salvage value +1/2 (Initial investment - salvage value)

*Accounting Rate of Return (ARR) = Average net annual income/ Average Investment

Project B has higher ARR 16%. So, project B is better investment option in comparison to project A and C.