(137)---EVALUATION OF ACCOUNTING RATE OF RETURN (ARR)

Evaluation of Accounting Rate of Return

The accounting rate of return (ARR) method may have some merits:

• Simplicity. The accounting rate of return (ARR) method is simple to understand and use.
• Accounting date. The accounting rate of return (ARR) can be readily calculated from the accounting data; unlike in the net present value (NPV) and internal rate of return (IRR) methods, no adjustments are required to arrive at cash flows of the project.
• Accounting profitability. The accounting rate of return (ARR) rule incorporates the entire stream of income in calculating the project’s profitability.

The accounting rate of return (ARR) is a method commonly understood by accountants, and frequently used as a performance measure. As a decision criterion, however, it has serious shortcomings.

• Cash flows ignored. The accounting rate of return (ARR) uses accounting profits, not cash flows, in appraising the projects. Accounting profits based on arbitrary assumptions and choices and also include non-cash items.
• Time value ignored. The averaging of income ignores the time value of money. In fact, this procedure gives more weight age to the distant receipts.
• Arbitrary cut off. The firm employing the accounting rate of return (ARR) rule uses an arbitrary cut-off yardstick. Generally, the yardstick is the firm’s current return on its assets (book-value). Because of this, the growth companies earnings very high rates on their existing assets may reject profitable projects with positive net present values and the less profitable companies may accept bad projects with negative net present values.