Accounting Rate of Return – Capital Budgeting Techniques
Accounting rate of return is the project evaluation technique which differs from other capital budgeting techniques because the focus of this technique is average annual net income or accounting income rather than cash flows. ARR is defined as the ratio of average accounting income to average investment. You will find number of variations on the ARR formula. while calculating accounting rate of return, initial investment is sometimes used instead of average investment . A widely used formula for computing Accounting Rate of Return is:
Accounting rate of return = average annual net income/average investment
Average Investment= (Initial Value + Ending Value)/2)
To calculate Average Annual Net Income we take total income over the project’s life, less initial investment and divide that numeral by the number of years.
The investment project is accepted if the accounting rate of return is greater than the established standard or cost of the project. In case of mutually exclusive projects, project with the highest ARR should be selected.
ARR is used as primary criterion in some cases but it is also used for supplementary information while making investment decisions mostly for following reasons:
Accounting rate of return is easy to calculate. We don’t need to use complex formulas for that purpose. The figures required to calculate ARR are easily available from financial statements.
ARR is mostly used to test new products and services by financial institutions as main assets of FI are financial instruments and there is very little involvement of depreciation and working capital.
ARR reflects the significance of accounting income for the managers who are concerned about reporting income to their shareholders. However, their reliability on accounting income decreases when they succeed in establishing credibility with shareholders.
The popularity of accounting rate of return has been declined as a principal criterion because of following weaknesses:
ARR does not take into consideration the time value of money. Income in the fifth years counts the same as income in the first year.
ARR also ignores the life of the project. A $50000 investment that generates $10000 a year will have the same ARR whether it has a life of 5 year or 15 years.
ARR is based on accounting income not on cash flows. It focuses on accounting reports prepared for shareholders and others than the benefits actually received by the firm.