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Average Accounting Return

Average Accounting Return (AAR) is a financial metric used to evaluate the profitability of an investment or project. It is calculated by dividing the average annual accounting profit by the average investment over the life of the project. Unlike other profitability metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR), AAR does not consider the time value of money, which means it treats all profits equally, regardless of when they are received.

Example

Consider a company that invests $200,000 in a new project. Over the next five years, the project generates an average annual accounting profit of $30,000. The AAR would be calculated as $30,000 (average profit) divided by $200,000 (average investment), resulting in an AAR of 15%.

Key points

• AAR provides a simple measure of profitability by comparing average profit to average investment.

• Does not consider the time value of money, making it less accurate than other financial metrics.

• Useful for quick assessments but not for detailed investment analysis.

Quick Answers to Curious Questions

AAR does not account for the time value of money, which means it may overestimate the profitability of projects that generate profits later rather than sooner.

AAR is helpful for making quick comparisons between potential investments, particularly in the early stages of decision-making.

Unlike IRR, which considers when profits are earned, AAR simply averages them, potentially giving a less accurate picture of an investment's true profitability.