How is the average accounting return (AAR) calculated?

The average accounting return (AAR) is calculated by taking the average net income generated from an investment and dividing it by the average book value of that investment. This metric measures the profitability of an investment relative to its accounting value, giving an indication of how effectively the capital is being used to generate income over time.

To elaborate, the average net income reflects the earnings generated by the investment over a specific period, while the average book value represents the investment's value on the company's balance sheet over that same period. This calculation provides a straightforward method for investors and managers to assess the performance of an investment by relying on accounting figures rather than cash flows, enabling comparisons across different projects or investments.

The other options do not align with the correct calculation of AAR. For instance, average net income divided by total cash flow does not accurately reflect the return on investment as it mixes different financial concepts. Similarly, total equity divided by total liabilities provides insights into a company's financial structure but does not address investment returns. Lastly, net profits divided by initial investment does not consider the average book value of the investment over its lifespan, which is essential for a proper AAR calculation.