On January 1, 20X1, Darth Corp. (a fictional company) granted nonqualified stock options to certain key employees as additional compensation. The options were for 100,000 shares of Darth’s $1 par value common stock at an exercise price of $24 per share. The market price of this stock on January 1, 20X1, was $20 per share. The options were exercisable beginning January 2, 20X3, and expire on December 31, 20X9. Based on the Black–Scholes model, the options were valued at $16 per option at the date of grant. On July 1, 20X3, when Darth’s stock was trading at $55 per share, all the options were exercised. Darth has a marginal tax rate of 21%. Darth’s deduction for compensation expense will not be affected by the $1 million limit. 

Required:

1. Prepare all the necessary pre-tax journal entries related to the stock options from January 1, 20X1, to July 1, 20X3.

2. Prepare all the necessary journal entries to record the tax effects related to the stock options from January 1, 20X1, to July 1, 20X3.

3. Show how the option exercise will affect Darth’s income tax expense in 20X3, and explain how the change in income tax expense impacts Darth’s effective income tax rate.

4. Explain how the tax benefits associated with the July 1, 20X3, exercise will be shown in Darth’s statement of cash flows.