What is a primary disadvantage of using the Average Accounting Return (AAR)?

The primary disadvantage of using the Average Accounting Return (AAR) lies in the requirement of a subjective cutoff point for decision-making. AAR calculates the average net income expected from an investment relative to the average book value of the investment. The need for a predetermined threshold or cutoff point introduces a level of subjectivity into the analysis, as different investors or managers may have varying standards for what constitutes an acceptable return. This subjectivity can lead to inconsistent decision-making, as the choice of cutoff can significantly impact whether an investment is deemed acceptable or not.

Furthermore, the reliance on this subjective measure can obscure more objective financial realities, such as cash flow generation or risk assessment, which are critical for making sound investment decisions. By not being entirely grounded in tangible cash flows and relying instead on averages drawn from accounting income, the AAR may not provide the thorough financial insight necessary for confident investment choices.