What is the Accounting Rate of Return?

The accounting rate of return is the expected rate of return on an investment. 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.

How to Calculate the Accounting Rate of Return

The calculation is the accounting profit from the project, divided by the initial investment in the project. The formula for the accounting rate of return is as follows:

Average annual accounting profit ÷ Initial investment = Accounting rate of return

In this formula, the accounting 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. Also, the initial investment is calculated as the fixed asset investment plus any change in working capital caused by the investment. 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%.

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Problems with the Accounting Rate of Return

There are several serious problems with this concept, which are noted below:

Ignores 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 not incorporate this factor, so it clearly overstates the profitability of proposed projects. The overstatement is especially large when the projected duration of a project spans many years.
Ignores constraints. 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. Investments that increase throughput are the main drivers of increases in profitability, and yet many organizations do not include it in their analyses.
Ignores interrelated systems. 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. A stand-alone analysis might result in a project approval, when other elements of the surrounding system will have a negative impact on the investment, resulting in no clear gain as a result of the project.
Does not compare projects. 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. Ideally, a number of factors should be weighed by an experienced group of managers who are in the best position to decide which projects should proceed.
Ignores return on cash flows. 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. If non-cash expenses are substantial, then the difference from actual cash flows could be significant.
Ignores time-based risk. There is no consideration of the increased risk in the variability of forecasts that arises over a long period of time. This is a particular concern when the market within which a company operates is new, and its future direction is uncertain.

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.