Financial Glossary
Accounting Rate of Return (ARR)
The accounting rate of return (ARR) is a capital budgeting metric that expresses the expected average annual accounting profit from an investment as a percentage of the initial investment cost or average book value. Unlike internal rate of return or net present value, ARR uses accounting profit rather than cash flows and does not discount future returns for the time value of money. It provides a quick estimate of profitability relative to cost but is considered a less rigorous measure than discounted cash flow methods because it ignores timing and the present value of money.
Problem & Application
ARR is frequently used in owner-operated businesses as a quick screen for capital investments -- a campground operator considering whether to add a new amenity block or a self-storage owner evaluating a facility expansion may calculate ARR to get a rough return estimate before commissioning a full analysis. The limitation is that ARR can flatter investments with high early-year accounting profits by ignoring the degradation of asset value and the time value of future earnings. Using ARR in isolation without comparing it to a discounted cash flow or payback period analysis can lead to approving projects that look attractive on paper but generate poor actual returns.
In Short
ARR is a useful first-pass filter for capital investment decisions but should never be the only metric. Pair it with a discounted cash flow analysis to account for timing and the real cost of capital.