Accounting Rate

Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or averageinvestment. The accounting rate of return is based on accounting profits.the accounting rate of return (ARR), computed from the financial statements, is a periodic andan ex post indicator. Vatter (1966) ascertains that ARR is a figure based only on the data relatedto a given year, and is not referenced to other parts of the project except the year to which itapplies. It is commonly defined as the ratio of accounting profit earned in a particular period tothe book value of the capital employed in the period. According to the different numerators anddenominators applied to calculate ARR, there are several kinds of definitions used in analysis.For the numerator of ARR, it is usually financial annual accounting profit or income, while thedenominator is often determined by book value of assets or book value of equity. Employing theµclean surplus¶ concept, Peasnell (1982) defines ARR as the ratio of the accounting profit to the book value of assets at the beginning of the period

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4 Disadvantages of Accounting Rate of Return ±

y

The definition of cash inflows is erroneous; it takes into account profit after tax only. It,therefore, fails to present the true return.

y

Definition of investment is ambiguous and fluctuating. The decision could be biasedtowards a specific project, could use average investment to double the rate of return andthereby multiply the chances of its acceptances.

y