Accounting Rate of Return

The accounting rate of return, also known as the return on investment, uses accounting information, as revealed by financial statements, to measure the profitability of an investment. That is the ration of the average after tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly. Alternatively, it can be found out by dividing the total of the investments book values after depreciation by the life of the project. Thus, is an average rate and can be determined by the following equation,

Accounting rate of return = Average income / Average investment

Acceptance rule

Accounting Rate of Return

As an accept or reject criterion, this method will accept all those projects whose It is higher than the minimum rate established by the management and reject those projects which have rate less than the minimum rate. This method would rank a project as number one if it has highest accounting rate of return and lowest rank would be assigned to the project with lowest accounting rate of return.

Evaluation of Accounting Rate of Return

That method may have some merits:

• Simplicity. That method is simple to understand and use.

• Accounting date. The accounting rate of return can be readily calculated from the accounting data; unlike in the net present value and internal rate of return methods, no adjustments are required to arrive at cash flows of the project.

• Accounting profitability. For this method rule incorporates the entire stream of income in calculating the projects profitability.

It is a method commonly understood by accountants, and frequently used as a performance measure. As a decision criterion, however, it has serious shortcomings.

• Cash flows ignored. It uses accounting profits, not cash flows, in appraising the projects. Accounting profits based on arbitrary assumptions and choices and also include not-cash items.

• Time value ignored. The averaging of income ignores the time value of money. In fact, this procedure gives more weight age to the distant receipts.

• Arbitrary cut off. The firm employing that rule uses an arbitrary cut-off yardstick. Generally, the yardstick is the firms current return on its assets (book-value). Because of this, the growth companies earnings very high rates on their existing assets may reject profitable projects with positive net present values and the less profitable companies may accept bad projects with negative net present values.

Accounting Rate of Return
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