Accounting Rate of Return Formula Calculation

The accounting rate of return (AROR) is a financial metric used to evaluate the profitability of an investment based on accounting principles. Unlike the financial rate of return, which uses market values, AROR uses book values, making it particularly useful for accounting and financial reporting purposes.

What is Accounting Rate of Return?

The accounting rate of return measures the efficiency of an investment by comparing the net income generated by the investment to its average book value. It's commonly used in accounting and financial reporting to assess the profitability of investments held by a company.

Key characteristics of accounting rate of return include:

Uses book values rather than market values
Includes both income and expenses in the calculation
Provides a comprehensive view of investment profitability
Helps in financial reporting and analysis

Accounting Rate of Return Formula

The accounting rate of return formula is calculated using the following formula:

Accounting Rate of Return (AROR) = (Net Income / Average Book Value) × 100

Where:

Net Income is the profit generated by the investment after accounting for all expenses
Average Book Value is the average of the investment's book value at the beginning and end of the period

The result is typically expressed as a percentage.

How to Calculate Accounting Rate of Return

Calculating the accounting rate of return involves several steps:

Determine the net income from the investment for the period
Calculate the average book value of the investment
Divide the net income by the average book value
Multiply the result by 100 to get a percentage

This calculation provides a clear measure of how efficiently the investment is generating returns based on its book value.

Accounting vs. Financial Rate of Return

While both accounting and financial rates of return measure investment profitability, they differ in key ways:

Aspect	Accounting Rate of Return	Financial Rate of Return
Value Used	Book value	Market value
Purpose	Financial reporting	Investment evaluation
Calculation Basis	Net income and book value	Market price changes
Use Case	Company financial statements	Investor decision-making

Understanding these differences helps in selecting the appropriate metric for different financial analysis needs.

Example Calculation

Let's walk through an example to illustrate how to calculate accounting rate of return:

Example: A company invests $100,000 in a project. At the end of the year, the net income from the investment is $20,000, and the book value of the investment has appreciated to $120,000.

To calculate the accounting rate of return:

Calculate the average book value: ($100,000 + $120,000) / 2 = $110,000
Divide net income by average book value: $20,000 / $110,000 ≈ 0.1818
Multiply by 100 to get percentage: 0.1818 × 100 ≈ 18.18%

The accounting rate of return for this investment is approximately 18.18%.

FAQ

What is the difference between accounting rate of return and financial rate of return?

The accounting rate of return uses book values and is primarily for financial reporting, while the financial rate of return uses market values and is used for investment evaluation.

When should I use accounting rate of return instead of financial rate of return?

Use accounting rate of return for financial reporting and analysis within a company, while financial rate of return is more appropriate for investor decision-making.

Can accounting rate of return be negative?

Yes, if the net income is negative, the accounting rate of return will also be negative, indicating a loss rather than a return.