Internal audit and external audit both provide assurance, but they serve very different purposes. The most important distinction for many UK businesses is their legal status. An external audit may be required by law, while internal audit is generally voluntary for an ordinary UK private company, although it may be required by a regulator, lender, investor, or governance framework.
External audit focuses mainly on whether a company’s annual financial statements are accurate and present a true and fair view. Internal audit looks at how the wider business operates, including its risks, controls, and processes, and identifies areas for improvement.
For most businesses, the first question is whether an external audit is legally required.
When is an external audit legally required?
Under the Companies Act 2006, a company’s annual accounts generally require an audit unless the company qualifies for an exemption. The most common exemption is the small-company audit exemption.
For accounting periods beginning on or after 6 April 2025, if a company meets at least two of the three conditions below, it must do a statutory audit.:
| Test | Small-company threshold |
| Annual turnover | No more than £15 million |
| Balance-sheet total | No more than £7.5 million |
| Average number of employees | No more than 50 |
For example, a company with turnover of £17 million, assets of £6 million, and 40 employees meets the asset and employee conditions. It may therefore still qualify as small business even though its turnover exceeds £15 million and does not need a statutory audit.
However, qualifying as a small business (ie. Not meeting 2 of the three conditions above) does not automatically mean the company is exempt from audit. Other factors such as previous-year status, group structure, regulated activities, shareholder rights, contractual requirements, and the company’s articles of association may all affect the position.
The two-year rule
Company size should not always be assessed using one financial year alone. In its first financial year, a company will generally qualify as small if it meets the relevant conditions in that year. After this, size is normally assessed over two consecutive financial years.
A company that was previously small will not usually lose that status simply because it exceeds the limits for one year. Similarly, a company that has become medium-sized will generally need to meet the small-company conditions for two consecutive years before returning to the small-company regime.
How does being part of a group affect audit exemption?
A company may be below the individual size thresholds but still be unable to rely on the normal small-company audit exemption because it forms part of a larger group.
As before, for accounting periods beginning on or after 6 April 2025, a group must generally meet at least two of the following conditions to qualify as small:
| Test | Net group threshold | Gross group threshold |
| Aggregate annual turnover | No more than £15 million | No more than £18 million |
| Aggregate balance-sheet total | No more than £7.5 million | No more than £9 million |
| Aggregate average employees | No more than 50 | No more than 50 |
The gross figures broadly represent the combined figures of the group companies before transactions and balances between group members are removed. The net figures broadly represent the consolidated figures after items such as intercompany sales and balances have been removed.
Group example
Suppose a subsidiary has:
- turnover of £4 million;
- assets of £2 million; and
- 20 employees.
On its own, the subsidiary is well within the small-company thresholds. However, suppose the wider group has:
- gross turnover of £22 million;
- gross assets of £11 million; and
- 80 employees.
The wider group exceeds all three small-group thresholds. The subsidiary therefore cannot simply look at its own figures and assume it qualifies for the normal small-company audit exemption.
When can a company below the thresholds still require an audit?
Meeting the small-company thresholds does not always mean a company is exempt from audit. An audit may still be required if:
- The company is part of an ineligible group.
- The company carries out certain regulated activities.
- Shareholders with the required rights request an audit.
- The company’s articles of association require its accounts to be audited.
- A lender, investor, or other contractual agreement requires audited accounts.
Companies should also consider their wider corporate governance and statutory responsibilities. Professional company secretarial services can help businesses maintain statutory records and manage ongoing Companies House requirements.
A contractual requirement does not necessarily create a statutory audit obligation, but failing to obtain the required audit could put the company in breach of the agreement. If any of these circumstances apply, the company should confirm its position before relying on audit exemption.
What is internal audit?
Internal audit is an independent assurance and advisory function that reviews a business’s risks, controls, governance, and operational processes. Its purpose is to help directors and management identify weaknesses and improve how the organisation operates.
An internal audit may review areas such as:
- financial controls and supplier payments;
- payroll and expenses;
- stock management;
- cybersecurity and system access;
- regulatory compliance;
- fraud prevention; and
- management reporting and business continuity.
Internal audit may be carried out by an in-house team, an external specialist, or a combination of both. Regardless of the approach, internal auditors should remain objective and should not review activities for which they are directly responsible.
Benefits of internal audit
Internal audit can provide value beyond compliance by helping businesses identify weaknesses early, strengthen governance, and improve the way risks and operations are managed.
Stronger internal controls
Internal audit identifies weaknesses in existing controls and recommends practical improvements, helping reduce financial errors, operational failures, and opportunities for fraud.
Better risk management
Regular reviews help management identify emerging risks and assess whether appropriate measures are in place to manage them.
Improved operational efficiency
Internal audit can identify inefficient processes, duplicated effort, control gaps, and unnecessary costs, helping businesses operate more effectively.
Stronger governance and accountability
Independent insight gives directors and management greater visibility over how effectively responsibilities, controls, and decision-making processes are working.
Better regulatory compliance
Reviews can identify areas where processes do not align with legislation, regulatory requirements, or internal policies before they develop into more serious compliance issues.
More informed decision-making
Objective, evidence-based findings give management greater insight when making strategic and operational decisions.
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What is external audit?
An external audit is an independent examination of a company’s annual financial statements carried out by an independent registered statutory auditor. The auditor obtains evidence to form an opinion on whether the financial statements have been properly prepared under the applicable reporting framework and present a true and fair view.
An external audit provides reasonable assurance rather than an absolute guarantee. Auditors focus on material misstatements errors or omissions significant enough to influence decisions made using the financial statements. They do not normally check every transaction.
Benefits of external audit
External audit can provide value beyond satisfying a statutory requirement. Independent assurance can strengthen confidence in a company’s financial information and support important commercial relationships.
Increased investor confidence
Reliable financial reporting can give existing and prospective investors greater confidence when assessing the company’s financial position and performance.
Support when seeking finance
Banks and lenders may request audited accounts when considering lending or refinancing. Having independently audited financial statements can support these discussions.
Greater credibility and stakeholder confidence
Audited financial statements have been independently examined, giving shareholders, lenders, investors, and other stakeholders greater confidence in the company’s financial information.
Stronger financial reporting
The audit process may identify weaknesses or inconsistencies in financial reporting that management can address to improve future reporting.
Support for growth and transactions
Audited accounts can be valuable when a business is preparing for investment, a sale, significant financing, or other transactions where reliable financial information is important.
How do internal and external audit differ in practice?
The distinction becomes clearer when both auditors look at the same area of a business. Consider a company that holds significant stock across several warehouses.
Internal audit may ask:
- Who can change stock records?
- Are regular stock counts carried out?
- Are theft and system-access risks properly controlled?
- Is damaged or slow-moving stock properly monitored?
Its purpose is to help directors and management identify weaknesses, manage risks, and improve how the organisation operates.
External audit may ask:
- Does the stock physically exist and belong to the company?
- Have the quantities been recorded accurately?
- Has damaged or obsolete stock been valued appropriately?
- Were purchases and sales recorded in the correct accounting period?
- Is the stock balance reported in the financial statements materially accurate?
Internal audit asks whether the process is properly controlled. External audit asks whether the resulting financial information is materially correct.
Internal audit vs external audit – quick comparison
| Area | Internal audit | External audit |
| Legal status | Usually voluntary for an ordinary private company | May be legally required |
| Main purpose | Improve controls, risk management, governance and operations | Provide an independent opinion on the financial statements |
| Primary audience | Directors, management and audit committees | Shareholders or members |
| Scope | Can cover significant areas across the business | Primarily annual financial statements |
| Who performs it? | Internal or outsourced specialists | Independent registered statutory auditor |
| Frequency | Ongoing, periodic or one-off | Normally annual |
| Output | Findings, recommendations and action plans | Formal audit opinion |
| Can it replace the other? | Cannot replace a legally required external audit | Does not replace internal audit |
Which audit does your business need?
The answer depends on two questions: is an external audit required, and what additional assurance would benefit the business? Where an external audit is legally or contractually required, it cannot be replaced by internal audit. Even where an external audit is not required, a company may choose to have one voluntarily to provide additional assurance to shareholders, lenders, or investors.
Internal audit may be valuable where directors want greater insight into controls, governance, risks, systems, and operational processes. Some businesses need both, while others may need neither. The important point is that turnover alone does not determine the answer.
Conclusion
There is no single audit approach that suits every business. A company may require an external audit, benefit from internal audit, need both, or require neither. What matters is understanding your obligations and choosing the level of assurance that supports your business and its stakeholders.
If you’re unsure about your audit position, Pearl Accountants can assess your circumstances and provide practical guidance on audit exemption, statutory audit, and internal audit support.
Contact our audit specialists to discuss your requirements. This article provides general guidance based on the rules in force in August 2026. Audit requirements depend on the circumstances of each company, and professional advice should be obtained where there is uncertainty.
