Ceiling test definition

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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.

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.