How To Calculate Average Accounting Return In Excel

Calculate the average accounting return (AAR) for your investments using this interactive tool. Enter your annual net income and initial investment values below.

How to Calculate Average Accounting Return (AAR) in Excel: Complete Guide

The Average Accounting Return (AAR) is a fundamental financial metric used to evaluate the profitability of an investment based on its accounting earnings. Unlike discounted cash flow methods, AAR provides a simple percentage return that’s easy to calculate and interpret, making it particularly useful for quick investment comparisons.

What is Average Accounting Return?

AAR measures the average annual net income generated by an investment as a percentage of its average book value. It’s calculated by:

1. Determining the average annual net income over the investment’s life
2. Calculating the average book value of the investment
3. Dividing the average annual net income by the average book value

The formula for AAR is:

AAR = (Average Annual Net Income) / (Average Book Value) × 100%

When to Use Average Accounting Return

AAR is particularly useful in these scenarios:

• Quick investment comparisons: When you need to compare multiple investment opportunities rapidly
• Accounting-based evaluations: When your analysis focuses on accounting profits rather than cash flows
• Regulatory requirements: Some industries require AAR calculations for compliance reporting
• Initial screening: As a first-pass filter before more sophisticated analysis

Step-by-Step Guide to Calculating AAR in Excel

Step 1: Gather Your Data

Before calculating AAR in Excel, collect these essential pieces of information:

• Initial investment amount
• Annual net income for each year of the investment’s life
• Investment’s useful life in years
• Salvage value (if any) at the end of the investment’s life

Step 2: Calculate Average Annual Net Income

In Excel:

1. List annual net income values in consecutive cells (e.g., B2:B6)
2. Use the AVERAGE function: =AVERAGE(B2:B6)
3. This gives you the average annual net income

Step 3: Calculate Average Book Value

The average book value is calculated as:

Average Book Value = (Initial Investment + Salvage Value) / 2

In Excel:

1. Enter initial investment in cell C2 (e.g., 100000)
2. Enter salvage value in cell C3 (e.g., 10000)
3. Use formula: = (C2+C3)/2

Step 4: Calculate AAR

Now divide the average annual net income by the average book value:

1. Assuming average net income is in D2 and average book value in D3
2. Use formula: = (D2/D3)*100
3. Format the cell as percentage

Practical Example in Excel

Let’s work through a complete example. Suppose you’re evaluating an investment with:

• Initial investment: $150,000
• Useful life: 5 years
• Salvage value: $20,000
• Annual net incomes: $30,000, $35,000, $40,000, $38,000, $32,000

Year	Net Income ($)
1	30,000
2	35,000
3	40,000
4	38,000
5	32,000

Excel calculations would look like:

1. Average annual net income: =AVERAGE(B2:B6) → $35,000
2. Average book value: =(150000+20000)/2 → $85,000
3. AAR: =(35000/85000)*100 → 41.18%

Advantages and Limitations of AAR

Advantages:

• Simplicity: Easy to calculate and understand
• Accounting focus: Uses accounting profits that companies already track
• Quick comparisons: Allows rapid evaluation of multiple projects
• No time value consideration: Simple average without complex discounting

Limitations:

• Ignores time value: Doesn’t account for when cash flows occur
• Accounting distortions: Can be affected by accounting policies
• No risk consideration: Doesn’t factor in investment risk
• Limited to accounting profits: Excludes non-accounting value drivers

AAR vs. Other Investment Metrics

Understanding how AAR compares to other financial metrics helps in choosing the right tool for your analysis:

Metric	AAR	IRR	NPV	Payback Period
Basis	Accounting profits	Cash flows	Cash flows	Cash flows
Time value	No	Yes	Yes	Partial
Complexity	Low	High	Medium	Low
Best for	Quick comparisons	Complex projects	Value creation	Liquidity focus
Risk consideration	No	Implicit	Through discount rate	No

Advanced Excel Techniques for AAR Analysis

Scenario Analysis

Create a data table to see how AAR changes with different assumptions:

1. Set up your base case calculations
2. Create a two-variable data table (Data → What-If Analysis → Data Table)
3. Vary initial investment and average net income to see AAR sensitivity

Visualizing AAR with Charts

Enhance your analysis with visual representations:

1. Create a column chart showing annual net incomes
2. Add a line for the average net income
3. Include the AAR percentage in the chart title
4. Use conditional formatting to highlight years above/below average

Automating with Excel Functions

For recurring calculations, create a custom function:

1. Press Alt+F11 to open VBA editor
2. Insert a new module
3. Paste this code:

Function CalculateAAR(netIncomes As Range, initialInvestment As Double, salvageValue As Double) As Double
    Dim avgNetIncome As Double
    Dim avgBookValue As Double

    avgNetIncome = Application.WorksheetFunction.Average(netIncomes)
    avgBookValue = (initialInvestment + salvageValue) / 2
    CalculateAAR = (avgNetIncome / avgBookValue) * 100
End Function

Now you can use =CalculateAAR(B2:B6, C2, C3) in your worksheet.

Common Mistakes to Avoid

When calculating AAR in Excel, watch out for these pitfalls:

• Incorrect range selection: Ensure your net income range includes all years
• Forgetting salvage value: Omitting it will overstate the average book value
• Mixing cash flows and profits: AAR uses accounting profits, not cash flows
• Improper formatting: Forgetting to format the result as a percentage
• Ignoring outliers: One extremely high or low year can skew the average

Real-World Applications of AAR

AAR finds practical use in various business scenarios:

Capital Budgeting

Companies use AAR as an initial screen for potential projects. While not as sophisticated as NPV or IRR, it provides a quick reality check on whether a project meets minimum return thresholds.

Merger and Acquisition Analysis

During due diligence, acquirers calculate the target company’s AAR to assess how its accounting returns compare to industry benchmarks before proceeding with more detailed valuation methods.

Performance Evaluation

Divisional managers use AAR to evaluate the performance of business units or product lines, especially when compensation is tied to accounting metrics rather than cash flow performance.

Regulatory Reporting

Some industries (particularly utilities) must report AAR figures to regulatory bodies to demonstrate adequate returns on their rate bases.

U.S. Securities and Exchange Commission – Investment Analysis Guidelines

The SEC provides comprehensive guidelines on investment analysis methods, including accounting return measures, in their Office of Compliance Inspections and Examinations publications.

Harvard Business School – Capital Budgeting Techniques

Harvard’s working knowledge series offers in-depth analysis of various capital budgeting techniques, including when to appropriately use accounting-based measures like AAR. Visit their Working Knowledge archive for research papers on this topic.

IRS Guidelines on Depreciation and Book Value

The Internal Revenue Service provides detailed information on how to calculate book values for tax purposes, which can affect AAR calculations. Refer to Publication 946 for official guidance on depreciation methods that impact book values.

Frequently Asked Questions

Is AAR the same as Return on Investment (ROI)?

While similar, they’re not identical. ROI typically compares total return to initial investment, while AAR looks at average annual accounting returns relative to average book value. ROI doesn’t account for the timing of returns or the investment’s life.

Can AAR be negative?

Yes, if the average annual net income is negative (the investment consistently loses money), the AAR will be negative, indicating the investment is destroying value.

How does depreciation affect AAR?

Depreciation reduces accounting net income, which lowers the numerator in the AAR calculation. However, it also reduces the book value over time, which affects the denominator. The net effect depends on the depreciation method used.

Should I use AAR for long-term investments?

AAR can be used for long-term investments, but it becomes less reliable the longer the time horizon because it doesn’t account for the time value of money. For long-term investments, NPV or IRR are generally more appropriate.

How often should AAR be recalculated?

You should recalculate AAR whenever there are significant changes to the investment’s expected cash flows, useful life, or salvage value. Many companies recalculate it annually as part of their budgeting process.