Walters Audio Visual, Inc., offers a stock option plan to its regional managers. On January 1, 2011, options were granted for 40 million $1 par common shares. The exercise price is the market price on the grant date, $8 per share. Options cannot be exercised prior to January 1, 2013, and expire December 31, 2017. The fair value of the options, estimated by an appropriate option pricing model, is $2 per option. Because the plan does not qualify as an incentive plan, Walters will receive a tax deduction upon exercise of the options equal to the excess of the market price at exercise over the exercise price. The income tax rate is 40%.

Required:

1. Determine the total compensation cost pertaining to the stock option plan.

2. Prepare the appropriate journal entries to record compensation expense and its tax effect on December 31, 2011.

3. Prepare the appropriate journal entries to record compensation expense and its tax effect on December 31, 2012.

4. Record the exercise of the options and their tax effect if all of the options are exercised on March 20, 2016, when the market price is $12 per share.

5. Assume the option plan qualifies as an incentive plan. Prepare the appropriate journal entries to record compensation expense and its tax effect on December 31, 2011.

6. Assuming the option plan qualifies as an incentive plan, record the exercise of the options and their tax effect if all of the options are exercised on March 20, 2016, when the market price is $11 per share.