In order for there to be privity between an accountant and a third party, the accountant must communicate directly with the third party, orally or in writing, the accountant's understanding and acknowledgment of the third party's intended reliance on the accountant's professional accounting service. In the case of banks, the communication from the accountant must be in writing. Absent the required communication from the accountant, there is no privity with the third party. Acknowledgment from an accountant providing a privity relationship for third parties other than banks, may be expressed by words or conduct. For the protection of all parties, in almost every case, it is best that such expression be made in writing. Where time is of the essence, an oral communication may be followed immediately by a written communication. In the case of third party banks, there must be a written acknowledgment from the accountant for a privity relationship to exist.
For third parties except banks, the privity law adopts a three-part test to determine whether a non-client will have privity with an accountant. All three parts of the test must be satisfied in order for a non-client to obtain privity.
The three part test requires that the accountant:
- Must have known at the time of the engagement, or agreed with the client after the time of the engagement, that the professional accounting service would be made available to the non-client who was specifically identified to the accountant in connection with a specified transaction made by the client;
- Knew the non-client intended to rely on the professional accounting service in connection with the specified transaction; and,
- Directly expressed to the non-client, by words or conduct, the accountant's understanding of the non-client's intended reliance on the professional accounting service.
In the case of clients that desire third party banks to obtain a privity relationship with an accountant, the law provides an abbreviated test. An accountant must acknowledge the bank's intended reliance on the professional accounting service, as well as the client's knowledge of that reliance, in a written communication. It is generally recommended that the accountant send the written communication to the accountant's client.
An accountant may not want a third party to have a privity relationship. This may be because the accountant believes the third party does not have a valid business reason for obtaining privity with the accountant, or the accountant wishes to send a "red flag" to the third party about the accountant's client by withholding privity, or due to some other reason (e.g., existence of significant uncertainties). Although the accountant's silence may be sufficient to withhold privity, a response to the client may be more appropriate under certain circumstances. Legal counsel should be consulted to limit any potential liability.
When CPAs provide reliance letters for compilation reports to a third party the CPA may be representing that the compilation report provides greater assurance than what is intended, since a compilation report is limited to presenting information that is the representation of management. To the extent that a third party seeks to rely upon any unusual services performed by the CPAs, the CPA should be similarly cautious. NJSCPA has developed a response form for compilations, which qualifies the acknowledgment and contains language regarding the limited nature of a compilation report.