Tests for consistency, Financial Management

Assignment Help:

Tests for Consistency

The consistency of the index numbers have been tested over the years. The most important of these tests are:

  1. The time reversal test

  2. The factor reversal test

  3. The circular test.

Time Reversal Test

Time reversal test has been developed by Prof. Irving Fisher. The test implies that for a price/quantity index, if the time periods are reversed, the resulting index should be the reciprocal of the original price/quantity index. 

If I0,1 denotes the original index for the current year with a given base year, and if I1, 0 denotes the resulting index, with time periods reversed, for the base year with the current year as a base year, then according to the time reversal test,

I0, 1 = 

1571_time reversal test.png  (or) I0, 1 x I1, 0 = 1

Let us test the consistency of the indices by interchanging 0 and 1 with 1 and 0 respectively.

It can be shown that Fisher's Ideal Index, Marshall-Edgeworth Index and Fixed Weights Aggregate Index satisfy this test. Laspeyres Index and Paasche Index do not. 

Factor Reversal Test

This test was also suggested by Prof. Irving Fisher. According to Prof. Fisher just as each formula should permit the interchange of the two time periods without giving inconsistent results, it ought to permit interchanging of the prices and quantities without giving inconsistent result, i.e. the two results multiplied together should give the true value ratio.

The product of change in prices in the current year and the change in quantities in the current year should be equal to  246_time reversal test1.png  (Value ratio)

where,

P1=Prices in the current year

P0=Prices in the base year

Q1=Quantities in the current year

Q0=Quantities in the base year

The test can be applied to the index numbers by interchanging P to Q and Q to P.

Except Fischer's Ideal Index, all other elementary indices, simple as well as weighted, fail to satisfy this test. 

Circular Test

Circular test is an extension of the time reversal test. This test is used while measuring price changes over a number of years with the shifting of base occurring frequently. According to this test, an index constructed for the year 'X' on base year 'Y' and for the year 'Y' on base year 'Z' should yield the same result as an index constructed for 'X' on base year 'Z'.

i.e. I0,1 x I1,2 x I2,0 = 1.

Laspeyres, Paasche and Fisher's indices fail to satisfy this test. Only the fixed weight aggregates method and simple aggregates method satisfy this test.

The indices satisfying the circular test would be amenable to change from year to year without referring to the base year. The indices have the advantage of reduced computational work in the event of a change in the base year.


Related Discussions:- Tests for consistency

Explain the bird in the hand theory of cash dividends, Explain the bird in ...

Explain the bird in the hand theory of cash dividends. The bird in the hand dividends theory state that dividends received now are better than a promise of future dividends.  U

Role of custodians, Role of Custodians The Securities and Exchange Boar...

Role of Custodians The Securities and Exchange Board of India on 5th May, 1996, through its notification No.S.O.344 (E) has issued the SEBI (Custodian of Securities) Regulation

Explain discounting or present value concept, Q. Explain Discounting or Pre...

Q. Explain Discounting or Present Value Concept? Discounting or Present Value Concept: - According to this concept rupee one of today is more valuable than rupee one a year lat

Compare and contrast j''s current style of management, When J was promoted ...

When J was promoted to be the new Sales and Marketing Manager for Company L, after working there in different capacities over the last ten years, it was a popular choice between he

Show the motives of maintaining receivables, Q. Show the Motives of Maintai...

Q. Show the Motives of Maintaining Receivables? Motives of Maintaining Receivables :- (i) Sales Growth Motives: - The major objectives of credit sales are to increase the to

Regarding the assigment below, a-ii, should i calculate the co-variance of ...

a-ii, should i calculate the co-variance of the 30 securities?

Working capital financing plan for company implementation, What is the most...

What is the most conservative type of working capital financing plan a company could implement?  Explain. An all equity capital structure would be the mainly conservative type

What do you mean by letter of credit, Q. What do you mean by Letter of Cred...

Q. What do you mean by Letter of Credit? A letter of credit is an arrangement whereby a bank helps its customer to obtain credit from its (customer's) suppliers. When a bank op

State about the nick leeson and barings, Nick Leeson and Barings Leeson...

Nick Leeson and Barings Leeson was the trader who managed to bring about the collapse of Barings Bank in 1995. The main reason he was able to do this was because there was a ce

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd