Accounting rate of return (ARR) is also known as average rate of return. ARR is based upon accounting information rather than on cash flow. In other words, accounting rate of return (ARR) refers to the rate of earning or rate of net profit after tax on investment.
ARR consider profitability rather than liquidity. Under ARR technique, the average annual expected book income is divided by the average book investment in the project.
ARR = (Average net income/Average investment) x 100
Average net income= Total net income/No. of years
Average investment= Net investment/2
Decision Rules of Accounting Rate Of Return (ARR)
- If projects are independent
Accept the project which has higher ARR than standard.
Reject the project which has lower ARR than standard.
- If projects are mutually exclusive
Accept the project which has highest ARR
Reject other projects.
Advantages of Accounting Rate of Return (ARR)
- ARR is based on accounting information; therefore, other special reports are not required for determining ARR.
- ARR method is easy to calculate and simple to understand.
- ARR method is based on accounting profit hence measures the profitability of investment.
Disadvantages of Accounting Rate OF Return (ARR)
- ARR ignores the time value of money.
- ARR method ignores the cash flow from investment
- ARR method does not consider terminal value of the project.