They are supposed to show your location, but it's not what actually happens.
I've seen the flag system failing many times, from showing no location at all (the "toribash" flag), to completely different locations - I'm from Brazil and there was a time that I had my flag show as spain, but no one else had accessed my account.
It can also be dodged pretty easily with a proxy.
I like the idea of customizing the flag, since it's something to sink TC, I doubt it will be accessible for most people, making the original flag system still useful.
I support this.