Accounting Rate of Return

Definition

• Accounting Rate of Return (ARR): Return earned on an investment using accounting-based measurement, specifically accrual accounting.
• Focuses on traditional accounting methods instead of cash flows.

Example: Hogarth's Machine

• Investment: $23,000 on a machine.
• Cash Savings Over Four Years:
  • Year 1: $10,000
  • Year 2: $8,000
  • Year 3: $6,000
  • Year 4: $5,000
  • Total Savings: $29,000
• Average Annual Savings: $29,000 / 4 = $7,250 per year.

Depreciation

• Depreciation Method: Straight-line.
• Annual Depreciation Expense: $23,000 / 4 = $5,750 per year.

Calculation of ARR

• Average Cash Savings per Year: $7,250
• Annual Depreciation Expense: $5,750
• Return (Numerator): $7,250 - $5,750 = $1,500
• Investment (Denominator): $23,000
• ARR: ($1,500 / $23,000) = 6.52%

Advantages of ARR

• Simplicity: Easy to compute like the payback period.
• Accounting-Based: Aligns with financial statement effects and comparable to accounting-based required rates of return.
• Language Compatibility: Useful when accountants and managers are communicating within accounting terms..

Disadvantages of ARR

• Focus on Accounting Over Cash Flows: Does not emphasize cash inflows vs. outflows, which are crucial for assessing project feasibility.