Accounting Rate of Return (ARR) (Cambridge (CIE) A Level Accounting): Revision Note

Accounting rate of return (ARR)

What is the accounting rate of return (ARR)?

• The accounting rate of return measures the average annual profit as a percentage of the average investment

• It is the only investment appraisal method that uses profit, not cash flows

• Owners usually prefer investments which have a higher accounting rate of return

• If the accounting rate of return is higher than the target rate, then the project is usually accepted

• If the accounting rate of return is lower than the target rate, then the project is usually rejected

How do I calculate the accounting rate of return?

• STEP 1
  Calculate the net cash flow for each year

• STEP 2
  Calculate the average profit

  • Add together the net cash flows including Year 0

    • Including Year 0 makes sure the depreciation is subtracted from the cash flows

    • The residual value in your exam will always be zero, and therefore, the total depreciation is equal to the initial investment

  • Divide by the number of years

    • Don't count Year 0

• STEP 3
  Calculate the average investment

  • The residual value will always be zero in your exam

  • Therefore, the average investment is equal to half the initial cost

    • 

• STEP 4
  Calculate the accounting rate of return

  • 

    • Write as a percentage

What are the advantages and disadvantages of the accounting rate of return method?

Advantages

• It uses profit

  • This makes it easy to compare with ROCE targets

  • Managers are familiar with working with the profit

• It is expressed as a percentage

  • This makes it easy to compare with target rate

• It considers all years of the project

Disadvantages

• It ignores the time value of money

• It uses the average profit

  • This can be misleading

• It ignores timing of cash flows