The average accounting return (AAR) is the average project earnings after

taxes A tax is a mandatory financial charge or levy imposed on an individual or legal entity by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax co ...

and

depreciation In accountancy, depreciation refers to two aspects of the same concept: first, an actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation i ...

, divided by the average

book value In accounting, book value (or carrying value) is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made ...

of the investment during its life. Approach to making

capital budgeting Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, repla ...

decisions involves the average accounting return (AAR). There are many different definitions of the AAR. However, in one form or another, the AAR is always defined as: Some measure of average accounting profit divided by some measure of average accounting value. The specific definition we will use is: Average net income divided by Average book value. It is kinds of decision rule to accept or reject the finance project. For decide to these projects value, it needs cutoff rate. This rate is kind of deadline whether this project produces net income or net loss. {{cite book, title=Corporate Finance, url=https://archive.org/details/essentialsofcorp00ross_2, url-access=registration, author1=Ross, Stephen A., author1link=Stephen Ross (economist) , author2=Randolph W. Westerfield , author3=Jeffrey Jaffe , name-list-style=amp , page
166
publisher=McGraw-Hill/Irwin, year=2008, isbn=978-0-07-310590-1 There are three steps to calculating the AAR. First, determine the average

net income In business and Accountancy, accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and Amortization (a ...

of each year of the project's life. Second, determine the average

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

, taking depreciation into account. Third, determine the AAR by dividing the average net income by the average investment. After determine the AAR, compare with target cutoff rate. For example, if AAR determined is 20%, and given cutoff rate is 25%, then this project should be rejected. Because AAR is lower than cutoff rate so this project will not make sufficient net income to cover initial cost. Average accounting return(AAR) does have advantages and disadvantages. Advantages; It is easier to calculate than other capital budgeting decision rules. It only needs net income data and book values of the investment during its life. Another advantage is needed information will usually be available. Disadvantage; it does not take time value of money into account. When we average figures that occur at different times, we are treating the near future and the more distant future in the same way. Therefore, there is no clear indication of profitability. Also the use of an arbitrary benchmark cutoff rate is a disadvantage. The last disadvantage is it is based on accounting net income and book values, not cash flows and market values.

References

Financial ratios Capital budgeting

See also

References