Accounting Rate of Return Definition
Accounting Rate of Return Definition
The accepted accounting rate of return definition is a ratio of profit to employed capital assets calculated before tax and interest and measured for a fixed period of time. Many financial analysts prefer the accounting rate of return method over other methods since it provides a useful basis for comparison of profitability and risk of various investment options. For this reason, a more pragmatic accounting rate of return definition includes reference to its utility in capital budgeting; the accounting rate of return is often used by companies to determine which of several competing projects is likely to offer the highest reward-to-risk ratio.
Accounting Rate of Return Formula
While a number of different variations on the basic accounting rate of return formula exist, the formula is usually defined as:
• ((Total cash inflows) – (Depreciation))/(Initial investment) = (Accounting rate of return)
Depreciation is determined by a simple formula as well, usually
• ((Initial cost of equipment) – (Recoverable salvage value))/(Years of useful service) = (Depreciation) The accounting rate of return is expressed as a percentage, and allows direct comparison of profitability margins for disparate investments or projects. For example, if a company were deciding between two different capital investments, it would first determine likely depreciation for each option using the formula for depreciation outlined above. Then, by estimating the likely profit to be derived from each capital investment, subtracting the calculated depreciation, and dividing the resulting figure by the cost of the initial investment, the company could derive a comparable accounting rate of return result for each investment option. While predictive figures are obviously not as accurate as historical results, the accounting rate of return method offers a convenient way to compare capital investment options that cannot be compared directly with one another.
Accounting Rate of Return Advantages and Disadvantages
By comparing the predicted accounting rate of return for each investment under consideration, companies can assess which of competing purchases would offer the best financial return on investment; this adds a modicum of predictability and control to the decision-making process. After the purchase has been made, companies can use the accounting rate of return method to track the profitability and cost effectiveness of the capital investment. This can help companies plan more effectively and improve future decisions with regard to capital expenditures. Because the accounting rate of return method is relatively simple, it can be used for quick on-the-spot estimates, allowing companies to take advantage of immediate opportunities as they arise.
While listing accounting rate of return advantages, it’s essential to point out a few disadvantages to this useful accounting tool. The accounting rate of return method does not factor in the time value of money; this means it fails to account for the likely return on money invested through normal means, and thus renders an artificially high level of return for capital investment over traditional financial investment. Additionally, the accounting rate of return method uses income data rather than general cash flow information; this limits its accuracy for capital investments with high upkeep and maintenance costs, among others.
In many situations, the accounting rate of return method offers unique advantages to business owners, providing a useful way to compare capital expenditures and allowing them to act rapidly in response to opportunities while remaining financially responsible. The accounting rate of return offers ease of use and a basis for comparison for disparate capital investments; its utility and convenience make it a preferred quick accounting method for most corporate analysts and decision-makers.