What is meant by functional currency?

Functional currency refers to the currency of the primary economic environment in which an entity operates. This concept is crucial in financial reporting because it determines how an entity’s financial records are maintained and presented in its financial statements. The functional currency typically reflects the currency that predominantly influences the entity's revenue and expenses, allowing for accurate representation of its financial performance.

In practice, the functional currency is determined by considering factors such as the currency that is mainly used to conduct business transactions and the economic environment where the company primarily generates cash flows. Having a clear understanding of functional currency helps ensure that the financial statements provide relevant and reliable information to users, allowing them to make informed economic decisions.

Other options, while relating to currencies in different contexts, do not accurately capture the definition of functional currency in regards to financial reporting. Therefore, recognizing the primary economic environment as the basis for determining functional currency is essential in the preparation and presentation of financial statements.