The accounting rate of return is used in capital budgeting to estimate whether to proceed with an investment. The calculation is the accounting profit from the project, divided by the initial investment in the project. One would accept a project if the measure yields a percentage that exceeds a certain hurdle rate used by the company as its minimum rate of return. The formula for the accounting rate of return is:
Average annual accounting profit ÷ Initial investment
- Where the profit is calculated as the profit related to the project using all accruals and non-cash expenses required under the GAAP or IFRS frameworks (thus, it includes the costs of depreciation and amortization). If the project involves cost reduction instead of earning a profit, then the numerator is the amount of cost savings generated by the project. In essence, then, profit is calculated using the accrual basis of accounting, not the cash basis.
The result of the calculation is expressed as a percentage. Thus, if a company projects that it will earn an average annual profit of $70,000 on an initial investment of $1,000,000, then the project has an accounting rate of return of 7%.
There are several serious problems with the accounting rate of return concept, which are:
- Time value of money. The measure does not factor in the time value of money. Thus, if there is currently a high market interest rate, the time value of money could completely offset any profit reported by a project - but the accounting rate of return does incorporate this factor, so it clearly overstates the profitability of proposed projects.
- Constraint analysis. The measure does not factor in whether or not the capital project under consideration has any impact on the throughput of a company's operations.
- System view. The measure does not account for the fact that a company tends to operate as an interrelated system, and so capital expenditures should really be examined in terms of their impact on the entire system, not on a stand-alone basis.
- Comparison. The measure is not adequate for comparing one project to another, since there are many other factors than the rate of return that should be considered, not all of which can be expressed quantitatively.
- Cash flow. The measure includes all non-cash expenses, such as depreciation and amortization, and so does not reveal the return on actual cash flows experienced by a business.
- Time-based risk. There is no consideration of the increased risk in the variability of forecasts that arises over a long period of time.
In short, the accounting rate of return is not by any means a perfect method for evaluating a capital project, and so should be used (if at all) only in concert with a number of other evaluation tools. In particular, you should find another tool to address the time value of money and the risk associated with a long-term investment, since this tool does not provide for it. Possible replacement measurements are net present value, the internal rate of return, and constraint analysis. This measure would be of the most use for reviewing short-term investments where the impact of the time value of money is reduced.
The accounting rate of return is also known as the average rate of return or the simple rate of return.