The functional currency of an entity can be understood literally as the currency in which the entity functions. The choice of functional currency is a judgment that must be made under IAS 21. The judgment involves assessing the facts and deciding the currency on which the entity is most economically dependent.

For most entities, the functional currency is a clear judgment, as most entities operate primarily within a single economy or currency zone. However, IAS 21 provides guidance when the judgment proves difficult, especially if more than one currency is important to the entity.

IAS 21 suggests the following factors in determining the functional currency:

1. The currency that mainly influences sales prices for goods and services.
2. The currency of the country whose competitive forces and regulations primarily determine sales prices.
3. The currency that mainly influences labour, material, and other costs of providing goods or services.
4. The currency in which funds from financing activities are generated.
5. The currency in which receipts from operating activities are usually retained.

A combination of these factors is used to determine the functional currency that most closely reflects the primary economic environment in which the entity operates. (5 marks)