Final answer:
When using the equity method, the investor must defer profits on unsold inventory resulting from intra-entity transfers to be in line with the realization principle.
The correct answer to the question is E) The investor must defer upstream beginning inventory profits.
Step-by-step explanation:
When using the equity method of accounting for investments, the investor accounts for its share of the profits or losses of the investee which are reflected in its own income statement. When it comes to intra-entity inventory transfers, any unrealized profit for the unsold inventory at the end of the period should be eliminated from the income statement. This adjustment is because the profit is not realized from an external entity's point of view. Now, if the investor sells inventory to the investee (downstream transaction) and the inventory remains unsold by the investee, the investor needs to defer recognizing a portion of the profit from the sale until the investee sells the inventory to an outside party. If the investee sells inventory to the investor (upstream transaction) and the investor hasn't sold that inventory, similar deferral rules apply.
Given the choices, the correct option to select is:
E) The investor must defer upstream beginning inventory profits.
This is because any profit that was included in the beginning inventory's carrying amount due to an upstream sale that has not yet been realized by the end of the period from an external transaction must be deferred until it is realized.