Philadelphia School District's accounting procedures questioned in controller's report

Only days after the Internal Revenue Service began a detailed audit of the School District of Philadelphia, the city Controller's Office is poised to release a report that raises questions about district accounting procedures.

An audit by the Controller's Office of the comprehensive financial statement the district prepared for fiscal year 2010 found several serious accounting errors that if not corrected could have resulted in higher borrowing costs for the district.

According to a copy of the report The Inquirer obtained, City Controller Alan Butkovitz's office found four "material weaknesses" in the district's preliminary financial report for the fiscal year that ended June 30, 2010. The audit is scheduled for release Wednesday.

In response to concerns the audit raised, changes and corrections were made before the district issued its formal report Jan. 31.

Butkovitz said it marked the first time his office had found such serious problems with accounting procedures during its yearly review of district reports.

"When you wave a flag and say there is a 'material weakness,' that's like saying you can't automatically trust these statements," Butkovitz said. "You have to kick the tires and examine them."

Michael Masch, the district's chief financial officer, challenged the language in the controller's audit and said none of the questioned areas rose to the level of a "material weakness."

"A material weakness would misrepresent the actual financial condition of the school district," Masch said.

Among other things, the district's annual report is used by bond-rating agencies to grade its ability to repay debts. The City Charter requires the Controller's Office to audit the statement.

The report was due Dec. 31, but the Government Finance Officers Association of the United States and Canada, which reviews government reports, granted a 30-day extension.

Masch said the transactions the Controller's Office questioned included esoteric accounting technicalities that did not affect the statement of the district's assets or liabilities.

"I am completely perplexed at the Controller's Office decision to report this the way it did," Masch said.

He also said that in the past, the Controller's Office has understood that the preliminary documents the district provides are drafts subject to change.

But Deputy City Controller Gerald V. Micciulla, who oversaw the audit, said the problems auditors found were serious and increased the risk that other errors could slip by.

"On a scale of 1 to 10, this is a 10," he said. "When they give us these statements, these statements are supposed to be correct."

Butkovitz said the fact that the district had not spotted the errors was one of the factors that heightened auditors' concerns and figured in their decision to describe them as serious weaknesses.

"There are accounting rules that require us to broadcast to the world material weaknesses because of their significance in terms of the reliance the outside world puts on these accounting procedures," he said.

According to the copy of the controller's report The Inquirer obtained, auditors highlighted several issues, including a lack of documentation to support accounting decisions for several significant transactions. They said that the district's reviews were not always documented and that the procedures had failed to detect some significant errors. And auditors said the district had not circulated a completed manual on preparing the annual financial report to the offices that worked on it.

As one example of the lapses, the controller's report said the district improperly recorded a $15.3 million loan from its general fund to a food-service account.

With the approval of the Government Accounting Standards Board, the School Reform Commission in January approved a five-year repayment plan to restore the money to the general fund. Masch said the district had been working for three years to reduce the debt, which stems from an ill-fated experiment to privatize food service during the administration of former schools chief Paul Vallas.

The report also found that the district improperly recorded a $42 million adjustment from 2009 under new government accounting requirements related to payments the district made as part of a debt-restructuring deal to exit risky interest-rate swaps.

The district said it had followed the recommendation of a consultant hired specifically to deal with the new reporting requirements. Masch called the issue "a very esoteric dispute with the adjustment" that did not affect the district's bottom line.

The auditors in Butkovitz's office also said that on the day the district was required to submit its financial statement, they spotted a $6 million error in a payroll account.

In a May 13 letter responding to the controller's report, Masch said: "I would like to note the seriousness with which this administration treats the findings and recommendations." He said the district had made changes to resolve all the issues.

But the district's response to the audit repeatedly disputes the controller's characterization of the seriousness of the issues.

"The school district does not concur that there is a material weakness in the review of accounting entries," the response said.

The final report received certificates of excellence from the Association of School Business Officials and the Government Finance Officers Association of the United States and Canada. The certificates - which the district has received each year since the mid-1980s - indicate it has met the highest public accounting standards and help it obtain lower interest rates on debt.

Masch said the district has a high investment rating, "but not the very highest."

As of Dec. 31, Moody's gave the district a rating of Aa3 on one series of long-term debt; Standard & Poor's gave it an AA- rating.

The accounting concerns raised by the Controller's Office are one more bit of bad news for the district as it looks for more city and state aid to help address a $629 million shortfall.

The IRS last week began a wide-scale audit of the district's financial practices for the 2009 calendar year, The Inquirer reported Friday. As the audit began, the district abruptly fired its payroll director, Eileen Pelzer.

According to sources, the district blamed Pelzer for not informing top administrators about the audit's broadened scope. Sources said Pelzer, who has declined to comment, told them she had informed her supervisor about the IRS audit.

The IRS seeks information about reimbursements for travel and meals, use of district automobiles and credit cards, and "checking account data for payments that are processed outside the district's general fund," according to a document The Inquirer obtained that lists 28 separate areas of inquiry.

The district has downplayed the significance of the probe, calling it "a random, routine audit."