A transaction cycle is an interlocking set of business transactions.

Most business transactions can be

aggregated into a relatively small number of transaction cycles related to the sale of goods, payments to
suppliers, payments to employees, and payments to lenders. We explore the nature of these transaction
cycles in the following bullet points:

Sales cycle. A company receives an order from a customer, examines the order for creditworthiness,
ships goods or provides services to the customer, issues an invoice, and collects payment. This set of
sequential, interrelated activities is known as the sales cycle, or revenue cycle.

Purchasing cycle. A company issues a purchase order to a supplier for goods, receives the goods,
records an account payable, and pays the supplier. There are several ancillary activities, such as the use
of petty cash or procurement cards for smaller purchases. This set of sequential, interrelated activities is
known as the purchasing cycle, or expenditure cycle.

Payroll cycle. A company records the time of its employees, verifies hours and overtime worked,
calculates gross pay, deducts taxes and other withholdings, and issues paychecks to employees. Other
related activities include the payment of withheld income taxes to the government, as well as the
issuance of annual W-2 forms to employees. This cluster of activities is known as the payroll cycle.

Financing cycle. A company issues debt instruments to lenders, followed by a series of interest
payments and repayments of the debt. Also, a company issues stock to investors, in exchange for
periodic dividend payments and other payouts if the entity is dissolved. These clusters of transactions
are more diverse than the preceding transaction cycles, but may involve substantially more money.

A key role of the accountant is to design an appropriate set of procedures, forms, and integrated
controls for each of these transaction cycles, to mitigate the opportunities for fraud and ensure that
transactions are processed in as reliable and consistent a manner as possible.

The accounting process consists of several different cycles. Each cycle reflects a certain type of business
activity. Accountants define each transaction by activity and follow the same process to record and
report related information. The five accounting cycles are revenue, expenditure, conversion, financing
and fixed asset. The combined cycles repeat each accounting period.

Revenue

The revenue cycle has two major transaction groups: sales and cash receipts. Sales include all revenue
earned from goods and services purchased by consumers. Also included are sales discounts, returns or
allowances. Cash receipts represent the actual cash received by a company. Under accrual accounting —
the most popular method used to record transactions — sales and cash receipts are separate
transactions.

Expenditure
Expenditures represent the value given up to acquire goods or services necessary to run a business.
Transaction groups include inventory purchases, credit purchases, payroll and cash disbursements. Any
time a company expends cash, it falls under this accounting cycle. Expenditures are either a cost or an
expense. A cost will typically bring value to a company — such as an asset — while an expense is a one-
time use of capital.

Conversion

The conversion cycle accounts for the production of goods and services by a company. Cost accounting is
often a subunit of this cycle. Accountants will allocate production costs to all goods and services. The
conversion cycle takes information from the expenditure cycle and uses it to accurately expense all
produced items. This cycle can run in a continuous process rather than individual accounting periods.

Financing

Companies may need external financing to fund business operations. The financing cycle will record and
report information relating to stock, debt, bond and dividend transactions. The acquisition of external
financing and payments made to investors or lenders will fall under this cycle. Transactions may be less
frequent here if companies do not use external funds for their operations.

Fixed Asset

Capital investments represent the purchase of major assets used in operations. The purchase and
depreciation of fixed assets are common transactions in this cycle. Selling off old or outdated assets also
falls under this cycle. The fixed-asset cycle may have close ties to the financing cycle. Many companies
use external financing to purchase fixed assets. A fixed transaction can therefore have a related
transaction in the financing cycle.

Substantive procedures are intended to create evidence that an auditor assembles to support the
assertion that there are no material misstatements in regard to the completeness, validity, and accuracy
of the financial records of an entity. Thus, substantive procedures are performed by an auditor to detect
whether there are any material misstatements in accounting transactions.

Substantive procedures include the following general categories of activity:

Testing classes of transactions, account balances, and disclosures

Agreeing the financial statements and accompanying notes to the underlying accounting records
Examining material journal entries and other adjustments made during the preparation of the financial
statements

At a general level, substantive procedures related to testing transactions can include the following:

Examining documentation indicating that a procedure was performed

Reperforming a procedure to ensure that the procedure functions as planned

Inquiring or observing regarding a transaction

Examples of substantive procedures are:

Bank confirmation

Accounts receivable confirmation

Inquire of management regarding the collectibility of customer accounts

Match customer orders to invoices billed

Match collected funds to invoices billed

Observe a physical inventory count

Confirm inventories not on-site

Match purchasing records to inventory on hand or sold

Confirm the calculations on an inventory valuation report

Observe fixed assets

Match purchase orders and supplier invoices to fixed asset records

Confirm accounts payable

Examine accounts payable supporting documents

Confirm debt

Analytical analysis of assets, liabilities, revenue, and expenses

Thus, an auditor who is testing a validity assertion regarding a company's fixed assets could conduct a
physical observation of the assets, and then test for record accuracy by evaluating whether there is an
asset impairment.
Substantive procedures are included in the audit plan around which an audit is structured. If the results
of substantive procedures are not as expected, additional procedures may be added to the audit plan.

Substantive Testing

Substantive testing is the stage of an audit when the auditor gathers evidence as to the extent of mis-
statements in a client's accounting records or other information. This evidence is referred to as
substantive evidence and is an important factor in determining the auditor's opinion on the financial
statements as a whole.

The audit procedures used to gather this evidence are referred to as substantive procedures, or
substantive tests.

Substantive Tests

Substantive procedures (or substantive tests) are those activities performed by the auditor during the
substantive testing stage of the audit that gather evidence as to the completeness, validity and/or
accuracy of account balances and underlying classes of transactions.

Account balances and underlying classes of transaction must not contain any material misstatements.
They must be materially complete, valid and accurate. Auditors gather evidence about these assertions
by undertaking substantive procedures, which may include:

physically examining inventory on balance date as evidence that inventory shown in the accounting
records actually exists (validity assertion);

arranging for suppliers to confirm in writing the details of the amount owing at balance date as evidence
that accounts payable is complete (completeness assertion); and

making inquires of management about the collectibility of customers' accounts as evidence that trade
debtors is accurate as to its valuation.

Evidence that an account balance or class of transaction is not complete, valid or accurate is evidence of
a substantive misstatement.

Types of Substantive Procedures

There are two categories of substantive procedures:

analytical procedures; and tests of detail.

Analytical procedures generally provide less reliable evidence than the tests of detail. Analytical
procedures are applied in several different audit stages, whereas tests of detail are only applied in the
substantive testing stage.