Introduction

Average Accounting Return (AAR) is a financial metric used to assess the profitability of an investment based on accounting data. Unlike traditional return on investment (ROI) calculations that consider cash flows and market values, AAR focuses on accounting profits and book values.

This article delves into the significance of Average Accounting Return, how it is calculated, and its implications for evaluating investment performance.

The Role of Average Accounting Return: AAR provides insight into the financial performance of an investment from an accounting perspective. It allows investors and analysts to gauge the profitability of a project or investment by comparing the average accounting income generated over a specific period to the initial investment cost.

Calculating Average Accounting Return: To calculate the Average Accounting Return, follow these steps:

1. Determine the Average Accounting Income: Add the accounting income (profits) generated by the investment over a specific period (e.g., annual profits) and divide it by the number of periods.

2. Identify the Initial Investment Cost: Determine the initial investment cost or book value of the investment.

3. Compute the Average Accounting Return: Divide the Average Accounting Income by the Initial Investment Cost and express the result as a percentage.

Formula for Average Accounting Return: AAR = (Average Accounting Income / Initial Investment Cost) x 100

Implications of Average Accounting Return:

1. Focus on Accounting Metrics: AAR primarily considers accounting income, which may not capture all relevant cash flows and market values. As a result, it provides a limited perspective on investment performance.

2. Usefulness for Internal Decision-Making: AAR may be useful for companies making internal investment decisions based on accounting data. It helps assess the profitability of various projects and prioritizes investments based on accounting profitability.

3. Limitations for External Comparisons: When comparing investments or projects from different companies, AAR may not be suitable, as accounting practices and income recognition methods can vary.

4. Neglects Time Value of Money: AAR does not account for the time value of money or the impact of inflation, potentially providing an incomplete picture of investment performance over extended periods.

Conclusion

Average Accounting Return (AAR) is a financial metric used to evaluate investment profitability from an accounting standpoint. It considers accounting income and the initial investment cost to calculate the average return. While AAR can be valuable for internal decision-making within a company, it has limitations when used for external comparisons or when assessing long-term investment performance.

To gain a comprehensive understanding of an investment's true performance, investors and analysts should consider using a combination of financial metrics, such as ROI, net present value (NPV), and internal rate of return (IRR), that account for cash flows and the time value of money.