Ceiling test definition
/What is the Ceiling Test?
The ceiling test is a method used to keep the capitalized cost of a business from exceeding its underlying value. It is used by an oil and gas producer that employs the full cost method to account for its costs. Under the ceiling test, the net amount of costs in a cost center cannot exceed the sum of the items noted in the following calculation:
+ The present value of estimated future net revenues, minus any estimated future expenditures to develop and produce proved reserves, using a discount rate of 10%
+ The cost of any properties not being amortized
+ The lower of cost or the estimated fair value of unproved properties that are included in the amortized costs
- Any income tax effects associated with differences between the book and tax basis of the excluded properties and the unproven properties being amortized
If a cost center ceiling is exceeded, the excess amount is charged to expense. If the cost center ceiling later increases, the amount written off cannot be reinstated.
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Example of the Ceiling Test
Pelican Energy Ltd. uses the full-cost accounting method and has capitalized $500 million in costs for exploration and development activities.
Step 1: Calculate the Ceiling Limit
The ceiling limit is determined with the following calculation:
Ceiling Limit = PV of future net cash flows + Unproved property costs
+ Lower of cost or market value of unproduced reserves + Tax adjustments
PV of future net cash flows (discounted at 10%) = $420 million
Unproved property costs (net of impairment) = $50 million
Lower of cost or market value of unproduced reserves = $10 million
Tax adjustments = $20 million
Therefore, the total ceiling limit is: $420M + $50M + $10M + $20M = $500 million
Step 2: Compare Capitalized Costs to Ceiling Limit
Capitalized costs: $500 million
Ceiling limit: $500 million
Since the capitalized costs do not exceed the ceiling limit, no impairment is required.
Suppose oil prices fall, reducing the present value of future net cash flows to $350 million, while other components remain unchanged. This results in the following adjusted ceiling limit:
New Ceiling Limit = $350M + $50M + $10M + $20M = $430 million
Since capitalized costs remain at $500 million, this revised ceiling limit will require the company to recognize an impairment of $70 million, which is calculated as $500M - $430M = $70 million.