On January 2, 20X1, Dwyer Corporation (a fictional company) granted 4,000 nonqualified stock options each to 10 of its key executives (40,000 options in total). Under the terms of the option plan, upon exercise, each executive will pay the exercise price of $10 per share of common stock ($1 par value). The options were exercisable after January 1, 20X4, and the executives were required to be employees of Dwyer at the date of exercise. The Black–Scholes value of the option on the grant date is $12.50. Eight employees exercised options for 32,000 shares of stock on January 2, 20X5. Dwyer has a tax rate of 21% in all years. Dwyer’s deduction for compensation expense will not be affected by the $1 million limit. Relevant dates and stock prices are as follows:

January 2, 20X1 ........................................ $10
December 31, 20X1 ................................... 19
December 31, 20X2 ................................... 28
December 31, 20X3 ................................... 45
December 31, 20X4 ................................... 26
January 2, 20X5 .......................................... 26
December 31, 20X5 ..................................  25

Required:

1. Prepare the pre-tax compensation expense tax journal entries from 20X1 to 20X3. Round answers to the nearest dollar.

2. Prepare the journal entries required to record the stock option exercise on January 2, 20X5. Round answers to the nearest dollar.

3. Prepare journal entries to record the tax effects associated with requirements 1 and 2.

4. Prepare a schedule to show how the January 2, 20X5, option exercise affects Dwyer’s 20X5 income tax expense, and explain how the change in income tax expense affects its effective tax rate.