Accounting Rate Of Return vs. Internal Rate Of Return — What's the Difference?

Accounting Rate of Return (ARR) and Internal Rate of Return (IRR) are distinct methods used to evaluate the attractiveness of an investment or project. ARR calculates the return generated from the net income of the proposed investment, focusing on accounting profits to assess project viability. It is simple and easy to understand but does not consider the time value of money. On the other hand, IRR is a discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. It takes into account the time value of money and provides a percentage that signifies the profitability of the project.

ARR is straightforward, utilizing accounting information and emphasizing the average annual accounting profit and initial investment, making it a practical choice for quick assessments of project profitability. However, IRR, by incorporating the time value of money and cash flows, provides a more sophisticated and precise evaluation of an investment’s attractiveness. It reflects the actual gain on investment and is particularly useful for comparing projects with different scales and cash flow profiles, assisting in the optimal allocation of resources.

In the realm of investment appraisal, ARR’s simplicity and reliance on accounting data can be advantageous for initial screenings of investment opportunities. It provides quick insights based on historical data, aiding in swift decision-making processes. Conversely, IRR’s intricate calculations and consideration of cash flows offer more detailed and reliable insights into an investment's potential, enabling comprehensive analysis of investment options and facilitating informed investment decisions.

While ARR can give a general idea of the investment’s profitability, its ignorance of the time value of money and cash flow variability can lead to inaccuracies and skewed results, potentially overlooking viable investments. In contrast, IRR, by addressing these limitations, ensures a thorough and accurate representation of investment profitability, but its complexity may lead to difficulties in interpretation and application, requiring careful consideration and understanding.

Summarily, both Accounting Rate of Return and Internal Rate of Return have their place in investment appraisal, with ARR being suitable for a quick, general overview based on accounting data, and IRR offering a more detailed and accurate evaluation of investment profitability, considering the time value of money and varying cash flows.