FFM study guide reference E3b) requires candidates to not only be able to calculate the accounting rate of return, but also to be able to discuss the usefulness of the accounting rate of return as a method of investment appraisal.
Recent FFM exam sittings have shown that candidates are struggling with the concept of the accounting rate of return and this article aims to help candidates with this topic.
Candidates should note that accounting rate of return can not only be examined within the FFM syllabus, but also the F9 syllabus.
The accounting rate of return, also known as the return on investment, gives the annual accounting profits arising from an investment as a percentage of the investment made.
As we can see from this, the accounting rate of return, unlike investment appraisal methods such as net present value, considers profits, not cash flows. This is a vital point that many candidates forget in the exam.
Calculation
The formula for the accounting rate of return is (average annual accounting profits/investment) x 100%
Let us look at an example:
A company is considering in investing a project which requires an initial investment in a machine of $40,000. Net cash inflows of $15,000 will be generated for each of the first two years, $5,000 in each of years three and four and $35,000 in year five, after which time the machine will be sold for $5,000.
Calculating the numerator
We need the average annual accounting profit. To find this, the profit for the whole project needs to be calculated, which is then divided by the number of years for which the project is running (in this case five years).
Considering the profit for the project, let us draw up a simple profit and loss statement for the whole project:
$ | ||
---|---|---|
Cash inflow years 1 and 2 ($15,000 x 2) | 30,000 | |
Cash inflow years 3 and 4 ($5,000 x 2) | 10,000 | |
Cash inflow year 5 | 35,000 | |
Depreciation ($40,000 – $5,000) | (35,000) | |
Total profit for the project | 40,000 |
Next we need to convert this profit for the whole project into an average figure, so dividing by five years gives us $8,000 ($40,000/5).
Calculating the denominator
Now we have the numerator, we need to consider the denominator, i.e. the investment figure.
The investment figure can either be
So in this case:
Calculating the accounting rate of return
The accounting rate of return can now be calculated as either:
This approach should be used for any accounting rate of return calculation, no matter how easy or difficult:
Calculate the numerator:
Calculate the denominator
Look in the question to see which definition of investment is to be used. If the question does not give the information, then use the average investment method, and state this in your answer.
Calculate the accounting rate of return.
Show your answer as a percentage.
Usefulness
Having calculated the percentage answer, how can this be used for project appraisal?
The accounting rate of return percentage needs to be compared to a target set by the organisation. If the accounting rate of return is greater than the target, then accept the project, if it is less then reject the project.
This leads to a couple of problems:
Other problems with the accounting rate of return:
There are, however, some positive aspects to the accounting rate of return:
Candidates need to be able to calculate the accounting rate of return, and assess its usefulness as an investment appraisal method. It is hoped that this article will help candidates with both of these.
Written by a member of the FFM examining team