Accounting Rate of Return Calculation Example

The accounting rate of return (AROR) is a measure of investment performance that accounts for the time value of money using the accounting method. Unlike financial rate of return, AROR uses the initial investment cost rather than the book value of assets.

What is Accounting Rate of Return?

The accounting rate of return (AROR) is a financial metric used to evaluate the performance of an investment or project. It represents the percentage return on an investment based on the original cost of the investment, rather than the book value of the assets.

AROR is commonly used in accounting and financial reporting to assess the efficiency of investments. It helps investors and managers understand how well their investments are performing over time, considering both income and capital changes.

AROR is different from financial rate of return (ROI) because it uses the original cost of the investment rather than the book value of assets. This makes it particularly useful for accounting purposes where the original cost is more relevant than the current market value.

Accounting Rate of Return Formula

The formula for calculating the accounting rate of return is as follows:

Accounting Rate of Return (AROR) = (Net Income + Depreciation) / Initial Investment Cost

Where:

Net Income is the profit after all expenses, taxes, and interest.
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life.
Initial Investment Cost is the original amount invested in the asset or project.

This formula provides a clear measure of how much return is generated from the original investment, including both income and depreciation.

Accounting Rate of Return Example

Let's consider an example to illustrate how to calculate the accounting rate of return.

Example Scenario

A company invests $100,000 in a new machine. Over the year, the machine generates $50,000 in net income and has a depreciation expense of $20,000.

Using the formula:

AROR = ($50,000 + $20,000) / $100,000 = $70,000 / $100,000 = 0.70 or 70%

In this example, the accounting rate of return is 70%. This means the investment generated a 70% return based on the original cost of $100,000.

Comparison Table

Metric	Value
Initial Investment Cost	$100,000
Net Income	$50,000
Depreciation	$20,000
Accounting Rate of Return	70%

Accounting vs Financial Return

While both accounting and financial rates of return measure investment performance, they differ in their approach and application.

Key Differences

Accounting Rate of Return (AROR) uses the original cost of the investment, making it suitable for accounting and financial reporting purposes.
Financial Rate of Return (ROI) uses the book value of assets, which can be different from the original cost, especially if the asset has appreciated or depreciated.

Understanding these differences is crucial for investors and managers to make informed decisions about their investments.

FAQ

What is the difference between accounting rate of return and financial rate of return?: The accounting rate of return (AROR) uses the original cost of the investment, while the financial rate of return (ROI) uses the book value of assets. AROR is more suitable for accounting and financial reporting purposes.
How is depreciation included in the accounting rate of return calculation?: Depreciation is added to the net income in the AROR formula to reflect the systematic allocation of the cost of a tangible asset over its useful life.
Can the accounting rate of return be negative?: Yes, the accounting rate of return can be negative if the net income and depreciation combined are less than the initial investment cost.
Is the accounting rate of return the same as the internal rate of return?: No, the accounting rate of return is different from the internal rate of return (IRR). AROR is based on the original cost of the investment, while IRR is the discount rate that makes the net present value of all cash flows equal to the initial investment.