What Is Average Accounting Return (AAR) in Finance?

Average Accounting Return (AAR) is a financial metric used to evaluate the profitability of an investment or project. This metric assesses the financial viability of potential capital expenditures by focusing on accounting profits rather than cash flows. It provides a straightforward snapshot of an investment’s potential earnings from an accounting perspective, aiding in preliminary investment screening.

Average Accounting Return: Definition and Calculation

The Average Accounting Return (AAR) is a financial ratio that measures the average annual accounting profit of an investment relative to its average accounting investment. Accounting profit, also known as net income, represents a company’s total earnings calculated according to Generally Accepted Accounting Principles (GAAP). This profit figure includes all revenues and explicit expenses, such as operating costs, depreciation, interest, and taxes.

To calculate AAR, two main components are determined: the average annual net income and the average investment. The average annual net income is derived by summing the projected net income for each year of the project’s life and then dividing that total by the number of years. Depreciation, a non-cash expense, allocates the cost of a tangible asset over its useful life and reduces net income and taxable income.

The average investment is computed by taking the initial book value of the investment, adding its book value at the end of its useful life (often the salvage value), and dividing that sum by two. The AAR formula is: Average Accounting Return = Average Annual Net Income / Average Investment. The result is typically presented as a percentage.

For example, consider a project requiring an initial investment of $250,000, with a four-year useful life and no salvage value. Projected annual net incomes after taxes and depreciation are $30,500 (Year 1), $20,100 (Year 2), $25,200 (Year 3), and $15,800 (Year 4). The total net income is $91,600, yielding an average annual net income of $22,900 ($91,600 / 4).

The average investment is ($250,000 + $0) / 2 = $125,000. Applying the AAR formula, $22,900 / $125,000 results in an AAR of approximately 0.1832 or 18.32%. This indicates the average annual accounting return expected from the project.

Applying Average Accounting Return in Financial Analysis

Average Accounting Return serves as a tool in financial analysis, particularly for preliminary screening of investment opportunities. A higher AAR generally suggests a more profitable project from an accounting standpoint. Companies often establish a target AAR, also known as a hurdle rate, which represents the minimum acceptable return for a project to be considered viable. If a project’s calculated AAR meets or exceeds this internal benchmark, it may proceed to further evaluation.

This metric is useful for internal comparisons of projects, especially when evaluating multiple investment proposals. For instance, a business might use AAR to decide between two new equipment purchases, favoring the one with the higher percentage return. The simplicity of its calculation makes it appealing for initial assessments.

AAR can also guide decisions related to resource allocation and capital budgeting, providing insight into a project’s capacity to generate revenue and manage explicit costs. While it offers a straightforward measure of profitability, its application is often as a supplementary tool rather than the sole determinant for major investment decisions. It helps management assess performance and compare it against industry peers.

Average Accounting Return Versus Other Investment Metrics

Average Accounting Return differs from other common investment evaluation metrics, such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, primarily in its focus and treatment of time. AAR is based on accounting profits, or net income, which include non-cash expenses like depreciation. In contrast, NPV and IRR are discounted cash flow methods that analyze the actual cash inflows and outflows generated by a project.

AAR does not consider the time value of money, treating a dollar received today the same as a dollar received in the future. Unlike NPV and IRR, which explicitly discount future cash flows to their present value, recognizing that money available sooner has greater value. NPV calculates the net difference between the present value of cash inflows and outflows, yielding a dollar amount. IRR determines the discount rate at which a project’s NPV becomes zero, expressed as a percentage rate of return.

The Payback Period measures the time it takes for an investment’s cash inflows to recover its initial cost. Unlike AAR, which assesses overall profitability, the Payback Period focuses solely on liquidity and the speed of capital recovery. It typically uses cash flows rather than accounting profits and does not account for the time value of money or profitability beyond the recovery period.

While AAR provides a simple assessment of profitability based on financial statements, its reliance on accounting income rather than cash flows and its disregard for the time value of money mean it offers a different perspective than NPV, IRR, or Payback Period. Each metric serves a distinct purpose, with AAR offering insights into reported accounting performance, while cash flow-based methods provide a more comprehensive view of an investment’s economic viability over time.