A break clause is a simple concept: it is a clause within a contract/lease agreement that allows one, or multiple parties to end the lease before the actual stated end date.
It is common practice for lease agreements to contain a break clause, especially when the lease is in relation to the rental of a property (a tenancy agreement). They allow the lessee to have more control over when they can back out of the lease, which can be useful if they are subject to a significant change in circumstances which means they need to end the lease sooner than originally intended.
Break clauses also allow a lessor to have greater oversight of their leases. Most break clauses require the lessee to fulfil a set time period before they can end the lease early. Eg. a tenant renting a flat may be required to rent the flat for 6 months and after this period has been served, they can chose at any point to give 1 month’s notice before they end the lease.
Real Life Example
A relatively new business (Factory Limited) is looking to expand its operations and move into a larger factory. The business owner is unsure if the expansion will go as planned and is hesitant to sign a 5 year lease agreement for the factory.
An agreement is made with the landlord that a 5 year contract will be signed and if after serving a notice period of 9 months, Factory Limited wishes to end the lease they can do so by notifying the landlord 2 months in advance.
This is a win-win scenario for both parties involved:
- If things don’t go as planned and Factory Limited cannot keep up with their payments, they can back out of the lease early and no longer be legally obliged to make payments to the landlord for the remainder of the lease. However, if the expansion is a success they are able to continue renting the factory for another 4 years without disrupting day-to-day operations.
- The Landlord will not be left with a tenant who cannot afford to make rental payments each month and by having the security of a 2 month notice period, they know that if Factory Limited was to end the lease there are 2 months to find another business to rent the factory which will hopefully minimise any potential losses.
Accounting for a Break Clause
The method in which a break clause is accounted for can vary depending on which financial reporting framework is being used.
Here is a guide for FRS102: Disclosing Operating Leases with Break Clauses (FRS102)
For IFRS, the new lease standard IFRS 16 will be applicable.
For further details around IFRS 16 and lease disclosures, please see this handy guide we have put together,
How to identify a break clause
A break clause in a contract is often noticeable and may even be titled just that: “break clause”.
This is not always the case however. It is important to read through and fully understand the period that the contract ties the lessee to. Any mention of “notice periods” or giving “notice” is a sign of a break clause. It is also important to understand, in definite terms, the way in which you should give notice in the case that you need to make use of the break clause.
In summary, break clauses are an important part of a lease agreement that are beneficial to all parties involved in the lease/rental of an asset. Be sure to understand ALL clauses within the contract and have a clear understanding of what is expected from both sides of the agreement.
For further understanding of lease agreements I have attached the following link for your reference:
https://www.legalnature.com/guides/what-is-a-lease-agreement