Concept And Meaning Of Accounting Rate Of Return (ARR)
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
Where,
Average net income= Total net income/No. of years
Average investment= Net investment/2
Calculation Of Accounting Rate Of Return (ARR)
Illustration:
The initial investment of the project is $30,000. The net profit after tax is as follows:
Year............................Net profit after tax($)
1....................................25000
2....................................30000
3.....................................20000
4......................................25000
5......................................40000
Required: Accounting rate of return.
Solution
Calculation of ARR:
ARR = (Average net income/Average investment) x 100
= (28000/15000) x 100 = 18.67%.
Where,
Average net income = Total net income/No, of years
= 25000+30000+20000+25000+40000/5 = 28000
Average Investment = Net investment/2 = 30000/2 = 15000
Decision Rules Of Accounting Rate Of Return (ARR)
A. If projects are independent
Accept the project which has higher ARR than standard.
Reject the project which has lower ARR than standard.
B. If projects are mutually exclusive
Accept the project which has highest ARR
Reject other projects.
