What Is the After-Tax Real Rate of Return?

The after-tax real rate of return is the actual financial benefit of an investment after accounting for the effects of inflation and taxes. It is a more accurate measure of an investor’s net earnings after income taxes have been paid and the rate of inflation has been adjusted for. Both of these factors must be accounted for because they impact the gains an investor receives. This can be contrasted with the gross rate of return and the nominal rate of return of an investment.

Understanding the After-Tax Real Rate of Return

Over the course of a year, an investor might earn a nominal rate of return of 12% on his stock investment, but the real rate of return, the money he gets to put in his pocket at the end of the day, will be less than 12%. Inflation might have been 3% for the year, knocking his real rate of return down to 9%. And since he sold his stock at a profit, he will have to pay taxes on those profits, taking another, say 2%, off his return, for an after-tax real rate of return of 7%.

The commission he paid to buy and sell the stock also diminishes his return. Thus, in order to truly grow their nest eggs over time, investors must focus on the after-tax real rate of return, not the nominal return.

The after-tax real rate of return is a more accurate measure of investment earnings and usually differs significantly from an investment’s nominal (gross) rate of return, or its return before fees, inflation, and taxes. However, investments in tax-advantaged securities, such as municipal bonds and inflation-protected securities, such as Treasury inflation protected securities (TIPS), as well as investments held in tax-advantaged accounts, such as Roth IRAs, will show less discrepancy between nominal returns and after-tax real rates of return.

Example of the After-Tax Real Rate of Return

Let’s be more specific about how the after-tax real rate of return is determined. The return is calculated first of all by determining the after-tax return before inflation, which is calculated as Nominal Return x (1 – tax rate). For example, consider an investor whose nominal return on his equity investment is 17% and his applicable tax rate is 15%. His after-tax return is, therefore:
$0.17 \times (1 – 0.15) = 0.1445 = 14.45\%$0.17×(1−0.15)=0.1445=14.45%

Let’s assume that the inflation rate during this period is 2.5%. To calculate the real rate of return after tax, divide 1 plus the after-tax return by 1 plus the inflation rate, then subtract 1. Dividing by inflation reflects the fact that a dollar in hand today is worth more than a dollar in hand tomorrow. In other words, future dollars have less purchasing power than today’s dollars.

Following our example, the after-tax real rate of return is:

$\frac{(1 + 0.1445)}{(1 + 0.025)} – 1 = 1.1166 – 1 = 0.1166 = 11.66\%$(1+0.025)(1+0.1445)​−1=1.1166−1=0.1166=11.66%

That figure is quite a bit lower than the 17% gross return received on the investment. As long as the real rate of return after taxes is positive, however, an investor will be ahead of inflation. If it’s negative, the return will not be sufficient to sustain an investor’s standard of living in the future.

The Bottom Line

When you are assessing the value of your investments, it’s important to look at not just your nominal rate of return but also the after-tax real rate of return, which takes into account the taxes you’ll owe and inflation’s effect. The after-tax real rate of return can tell you if your nest egg investments will allow you to maintain your standard of living in the future.

What Is Accounting Theory?

Accounting theory is a set of assumptions, frameworks, and methodologies used in the study and application of financial reporting principles. The study of accounting theory involves a review of both the historical foundations of accounting practices, as well as the way in which accounting practices are changed and added to the regulatory framework that governs financial statements and financial reporting.

Understanding Accounting Theory

All theories of accounting are bound by the conceptual framework of accounting. This framework is provided by the Financial Accounting Standards Board (FASB), an independent entity that works to outline and establish the key objectives of financial reporting by businesses, both public and private. Further, accounting theory can be thought of as the logical reasoning that helps evaluate and guide accounting practices. Accounting theory, as regulatory standards evolve, also helps develop new accounting practices and procedures.

The most important aspect of accounting theory is usefulness. In the corporate finance world, this means that all financial statements should provide important information that can be used by financial statement readers to make informed business decisions. This also means that accounting theory is intentionally flexible so that it can produce effective financial information, even when the legal environment changes.

In addition to usefulness, accounting theory states that all accounting information should be relevant, reliable, comparable, and consistent. What this essentially means is that all financial statements need to be accurate and adhere to U.S. generally accepted accounting principles (GAAP). Adherence to GAAP allows the preparation of financial statements to be both consistent to a company’s past financials and comparable to the financials of other companies.

Finally, accounting theory requires that all accounting and financial professionals operate under four assumptions. The first assumption states that a business is a separate entity from its owners or creditors. The second affirms the belief that a company will continue to exist and not go bankrupt. The third assumes that all financial statements are prepared with dollar amounts and not with other numbers like units of production. Finally, all financial statements must be prepared on a monthly or annual basis.

Special Considerations

Accounting as a discipline has existed since the 15th century. Since then, both businesses and economies have greatly evolved. Accounting theory is a continuously evolving subject, and it must adapt to new ways of doing business, new technological standards, and gaps that are discovered in reporting mechanisms.

For example, organizations such as the International Accounting Standards Board help create and revise practical applications of accounting theory through modifications to their International Financial Reporting Standards (IFRS). Professionals such as Certified Public Accountants (CPAs) help companies navigate new and established accounting standards.

What Is Advertising Budget?

An advertising budget is an estimate of a company’s promotional expenditures over a certain time period. More importantly, it is the money a company is willing to set aside to accomplish its marketing objectives.

Understanding Advertising Budget

An advertising budget is part of a company’s overall sales or marketing budget that can be viewed as an investment in a company’s growth. The best advertising budgets—and campaigns—focus on customers’ needs and problems and on providing solutions to these issues, not company problems such as an overstock reduction.

When creating an advertising budget, a company must weigh the value of spending an advertising dollar against the value of that dollar as recognized revenue. Before deciding on a specific amount, companies should make certain determinations to ensure that the advertising budget is in line with their promotional and marketing goals:

• The target consumer — Knowing the consumer and having their demographic profile can help guide advertising spend.
• Best media type for the target consumer — Mobile or internet advertising, via social media, may be the answer, although traditional media, such as print, television, and radio may be best for a given product, market, or target consumer.
• Right approach for the target consumer — Depending on the product or service, consider if appealing to the consumer’s emotions or intelligence is a suitable strategy.
• Expected profit from each dollar of advertising spending — This may be the most important question to answer, as well as the most difficult.

Advertising Budget Levels

Companies can determine their advertising budget levels in several different ways, each of which has its positives and negatives:

1. Spend as much as possible — This strategy, which sets aside just enough money to fund operations, is popular with startups that see a positive return on investment on their advertising spend. The key is anticipating when the strategy will start showing diminishing returns and knowing when to switch strategies.
2. Allocate a percentage of sales — This is as simple as allocating a specific percentage based on the previous year’s total gross sales or average sales. It is common for a business to spend 2% to 5% of annual revenues on advertising. This strategy is simple and safe but is based on past performance and may not be the most flexible choice for a changing marketplace. It also assumes that sales are directly linked to advertising.
3. Spend what the competition spends — This is as simple as adhering to the industry average for advertising costs. Of course, no market is exactly the same and such a strategy may not be sufficiently flexible.
4. Budget based on goals and tasks — This strategy, wherein you determine the objectives and the resources needed to achieve them, has pros and cons. On the upside, this can be the most targeted method of budgeting and the most effective. On the downside, it can be expensive and risky.