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.
Related AccountingTools Course
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
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PV of future net cash flows (discounted at 10%) = $420 million
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Unproved property costs (net of impairment) = $50 million
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Lower of cost or market value of unproduced reserves = $10 million
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Tax adjustments = $20 million
Therefore, the total ceiling limit is: $420M + $50M + $10M + $20M = $500 million
Step 2: Compare Capitalized Costs to Ceiling Limit
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Capitalized costs: $500 million
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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.
