Accounting Rate of Return

The third decision-making method is called the accounting rate of return. The payback period focused on the amount of cash that we get. But the accounting rate of return doesn’t only focus on cash, it also includes non-cash items (e.g., depreciation expense) because it focuses on the net income that we generate.

If we think about the assets that we invest in, then we’re going to be depreciating them. Depreciation expense decreases our net income. The accounting rate of return is going to look at our net income instead of just the cash flows that are generated. From our prior example, we were investing in a new office building that created $25,000 a year of cash inflows.

Now let’s include the depreciation expense to see what the net income impact of it is. We invested $100,000 into the building, and let’s say it’s going to last 10 years. Our depreciation expense will be $10,000 a year. The cash inflow is $25,000, but then we have an expense of $10,000. We say that our accounting income is $15,000.

Study Tip: Accounting Return focuses on an investment’s return for a specific year based on the accounting income (not the cash flows).

The accounting rate of return method doesn’t care about the time value of money, and it’s also not trying to figure out how many years until we recover our investment. It’s simply looking at the rate of return that we’re getting on our investment. Our formula is accounting income divided by investment.

We’re getting accounting income per year of $15,000 because we subtracted depreciation and our initial investment was $100,000. Our accounting rate of return is therefore 15% ($15,000/$100,000). The accounting rate of return method measures our percentage return on investment for one year at a time. In other words, we don’t add all the accounting income throughout the entire asset’s life. Instead, it only uses one year of accounting income.

Accounting Rate of Return = Accounting Income / Investment