Needing an audit for the first time after growth

Q: How does the two year rule play out in practice?

Illustration only. A distributor with a 31 December year end has always been small. Its figures then grow: Year endedTurnoverBalance sheet totalEmployeesTests passedStatus 31 December 2026£12m£6m403Small, exempt 31 December 2027£17m£8m451Small, exempt (first breach) 31 December 2028£19m£9m550Not small, audit required The first audit is of the year to 31 December 2028. The opening balances for that audit are the balance sheet at 31 December 2027, which was prepared without an audit. If the 2028 figures had dropped back within two of the limits, the company would have stayed small and no audit would have been needed. The rule also works in reverse. A company that has lost small status only regains it, and with it the exemption, after meeting the small conditions in two consecutive years. One quieter year is not enough to stop the audit.

Q: What mistakes come up most often?

Treating the first breach as the trigger. Directors sometimes commission an audit a year early, or panic about a late audit that was never required. Forgetting the reverse rule. Dropping the audit after one smaller year, when two consecutive qualifying years are needed. Testing the wrong figure. The balance sheet total is gross assets, not net assets, so a company with heavy borrowing can breach it sooner than expected. Leaving the audit exemption statement on the balance sheet. The section 475 statements must only appear when the company is actually exempt. Appointing too late to see the opening count. This is the usual route to a qualified opinion on the first audited accounts, which then needs explaining to banks and customers. Ignoring the group. A small subsidiary can lose its exemption because the group has outgrown the small group limits. For how the audit itself runs once the auditor is appointed, see how a statutory audit works. Solar Protect provides tax investigation insurance for businesses and fee protection schemes for accountancy practices. Read how our cover works or get a quote.

A private company that has been small loses its audit exemption only when it exceeds the small company limits in two consecutive financial years, and the first audit is of the accounts for the second of those years. Because the year before was never audited, the auditor also has to get evidence about the opening balances, and stock is usually the hardest part. Directors who see the first year of growth coming have time to appoint an auditor early and avoid a qualified opinion.

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When does a growing company lose its audit exemption?

Section 477 of the Companies Act 2006 exempts a company from audit for a financial year in which it qualifies as small. Under section 382(3) a company meets the small conditions in a year if it satisfies at least two of three tests: turnover not more than £15 million, balance sheet total not more than £7.5 million, and an average of not more than 50 employees. These limits apply to financial years beginning on or after 6 April 2025; the earlier figures were £10.2 million and £5.1 million. For the first financial year beginning on or after that date, regulation 3 of SI 2024/1303 judges earlier years as if the new limits had always applied, so a company that breached only the old limits is not caught by the two year rule.

The trigger is not the first year above the limits. Section 382(2) says that where a company meets or ceases to meet the conditions, that changes its status only if it happens in two consecutive financial years. So a company that breaches two of the limits once stays small, and stays exempt, for that year. If it breaches them again the next year, it stops being small for that second year and its accounts for that year must be audited under section 475.

The numbers are explained in more detail on our page about company size thresholds, including how the turnover limit is scaled for a period that is not twelve months.

How does the two year rule play out in practice?

Illustration only. A distributor with a 31 December year end has always been small. Its figures then grow:

Year ended	Turnover	Balance sheet total	Employees	Tests passed	Status
31 December 2026	£12m	£6m	40	3	Small, exempt
31 December 2027	£17m	£8m	45	1	Small, exempt (first breach)
31 December 2028	£19m	£9m	55	0	Not small, audit required

The first audit is of the year to 31 December 2028. The opening balances for that audit are the balance sheet at 31 December 2027, which was prepared without an audit. If the 2028 figures had dropped back within two of the limits, the company would have stayed small and no audit would have been needed.

The rule also works in reverse. A company that has lost small status only regains it, and with it the exemption, after meeting the small conditions in two consecutive years. One quieter year is not enough to stop the audit.

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What else can force the first audit?

Growth is the usual reason, but not the only one. Section 478 excludes certain companies from the small company exemption whatever their size, such as public companies, banking and authorised insurance companies, and MiFID investment firms. Under section 479 a company that is a parent or subsidiary at any time in the year can use the exemption only if the whole group qualifies as small and is not an ineligible group. That means a small trading company can need an audit because the group it has joined has grown, even if its own figures have not.

Members can also insist. Under section 476, holders of at least 10% of the nominal value of the issued share capital, or of any class of it, can require an audit by notice given no later than one month before the end of the year concerned. GOV.UK also reminds companies that an audit is needed if the articles of association require one. See can shareholders demand an audit for the detail.

When does the auditor have to be appointed?

Section 485(1) requires a private company to appoint an auditor for each financial year unless the directors reasonably resolve that audited accounts are unlikely to be required. For a company coming out of exemption, section 485(3)(b) lets the directors appoint an auditor at any time following a period with no auditor, up to the next period for appointing auditors. That period is the 28 days beginning with the earlier of the deadline for sending out the previous year’s accounts to members and the day they were actually sent (sections 485(2) and 424).

In the illustration, the law would allow the directors to appoint the auditor fairly late, because the period for appointing auditors runs from when the 2027 accounts go out. In practice that is too late for a smooth audit. The auditor must be eligible under section 1212, meaning a member of a recognised supervisory body and eligible under its rules. More on the mechanics is in appointing and removing auditors.

Why are opening balances the hard part?

ISA (UK) 510 calls an audit where the prior period was not audited an initial audit engagement. Paragraph 6 requires the auditor to obtain sufficient appropriate evidence that the opening balances do not contain misstatements that materially affect the current year, and paragraph 8 asks whether the same accounting policies have been applied consistently.

Some balances look after themselves. Paragraph A6 notes that collecting opening debtors and paying opening creditors during the year gives some evidence about them. Stock is different: work on closing stock says little about what was on hand at the start. The standard suggests observing a current count and reconciling back to opening quantities, testing the valuation of opening items, and testing gross profit and cut off. For fixed assets and long term debt, paragraph A7 points to the underlying records and third party confirmations.

If the auditor cannot get enough evidence, paragraph 10 requires a qualified opinion or a disclaimer. The illustrative report in ISA (UK) 510 is exactly this case: the auditor was appointed partway through the year, did not see the opening stock count and could not satisfy itself by other means. Separately, ISA (UK) 710 paragraph 14 requires an Other Matter paragraph saying the comparative figures are unaudited. Our page on first year audits and opening balances covers the auditor’s procedures in more depth.

What should directors do in the first year over the limits?

The first breach year is a warning, and the most useful thing to do with it is plan as if the next year will also breach.

Appoint the auditor before the first breach year ends. If the auditor is in place by 31 December 2027 in the illustration, they can attend the count that becomes the opening stock for the first audited year. Our stocktake attendance page explains what they will look at.
Tidy the records behind the opening balance sheet. Fixed asset registers, loan statements, debtor and creditor listings and bank reconciliations should agree to the ledger at the start of the audited year.
Check accounting policies. If small company shortcuts were taken, or an estimate was handled loosely, it is better to correct it before the audit than to have it raised as an inconsistent policy under paragraph 8.
Budget for the wider reporting change. A company that is not small cannot use the small companies regime. A medium sized company must prepare a strategic report (section 414A applies once the small companies exemption is lost) and file its full accounts, directors’ report and the auditor’s report under section 445.

What mistakes come up most often?

Treating the first breach as the trigger. Directors sometimes commission an audit a year early, or panic about a late audit that was never required.
Forgetting the reverse rule. Dropping the audit after one smaller year, when two consecutive qualifying years are needed.
Testing the wrong figure. The balance sheet total is gross assets, not net assets, so a company with heavy borrowing can breach it sooner than expected.
Leaving the audit exemption statement on the balance sheet. The section 475 statements must only appear when the company is actually exempt.
Appointing too late to see the opening count. This is the usual route to a qualified opinion on the first audited accounts, which then needs explaining to banks and customers.
Ignoring the group. A small subsidiary can lose its exemption because the group has outgrown the small group limits.

For how the audit itself runs once the auditor is appointed, see how a statutory audit works.

Solar Protect provides tax investigation insurance for businesses and fee protection schemes for accountancy practices. Read how our cover works or get a quote.

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Sources

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.