Los Angeles Unified School District

Office of the Inspector General Internal Audit

Audit Report
Magnolia Science AcademyCharter Schools

OA 12 486

August 20, 2012

Los Angeles City Board of Education

Office of the Inspector General

Mnica Garca, President Tamar Galatzan Bennett Kayser Marguerite Poindexter LaMotte Nury Martinez Richard A. Vladovic Steve Zimmer
Members of the Board

August 20, 2012

John E. Deasy, Ph.D

Superintendent of Schools

Dr. Mehmet Argin Chief Executive Officer Magnolia Public Schools 13950 Milton Avenue, Suite 200B Westminster, CA 92683 Dear Dr. Argin:

Alfred Rodas
Inspector General, Interim

This is our report on the audit of selected Magnolia Science Academy-Charter Schools. These are the reports key sections: The Executive Summary describes the scope of the audit and provides an overview of what we audited and found. The two Findings and Recommendations section describes in detail the conditions we found, our recommendations and your comments. Appendix A is a summary of questioned costs identified in this audit. Appendix B is a summary of questionable accounting practices. Annex A contains your verbatim comments on our recommendations. Annex B lists other receiving copies of the report. Annex C lists the members of the audit team.

I appreciate the courtesies and cooperation extended to us during the audit.

Cc. Magnolia Public Schools Board of Directors

333 South Beaudry Avenue, 12th Floor, Los Angeles, California 90017 Telephone: (213) 241-7700 Fax: (213) 241-6826

About the Office of the Inspector General

The Office of the Inspector General reports directly to the Board of Education. We conduct independent audits, reviews and investigations of District operations, contracts and vendors in order to: Find ways to improve processes, programs, functions and activities Provide information that supports effective decision making Identify real or potential misuse of District resources Prevent and detect waste, fraud and abuse within the District Through our work, we strive to encourage a culture of accountability, transparency, collaboration and excellence and to assist the Board and the Superintendent in their efforts to provide a high quality education for the students and parents of the Los Angeles Unified School District.

Why did the OIG do this audit?

Charter Schools are now an important part of the public education system in the areas served by the District. Audits of selected charter schools are requested by the Charter School Division to assist them in their oversight responsibilities over charter schools. The audit of selected charter schools is part of the OIGs Annual Work Plan.

What was the main objective? To evaluate whether the Board of Directors and management of Magnolia Science Academy Charter Schools (MSA Schools) were adhering to the conditions, standards and procedures outlined in the Charter Agreement.

What OIG goals does this audit support? Find ways to improve processes, programs, functions and activities Provide information that supports effective decision making

What District key strategies does this audit support? Provide a portfolio of high quality schools for youth, families and communities Operate an effective, efficient, and transparent organization in order to assure the public trust

Areas requiring attention and what the District should do next are discussed briefly in the Executive Summary of this report.

TABLE OF CONTENTS

Executive Summary ..1

Findings and Recommendations

Finding A Compliance with Charter Agreement....5 Finding B Internal Controls....................................................................................................21

Appendix
Appendix A Questioned Costs....37 Appendix B Questionable Accounting Practices 38

Annexes
A Verbatim Comments ...39 B Report Distribution...................46 C Audit Team...........................47

EXECUTIVE SUMMARY
This report contains the results of our audit of Magnolia Science Academy Charter Schools (MSA Schools). The MSA Schools referred to in this audit were the Magnolia Science Academy-1, Magnolia Science Academy-2 and Magnolia Science Academy-3. The MSA Schools are part of twelve Magnolia Public Schools (MPS) operated by the Magnolia Educational and Research Foundation (MERF). The MSA Schools are located in Los Angeles, California and serve students from sixth grade through twelfth grade. The Magnolia Public Schools Central Office executes the decisions and policies set by the Magnolia Public Schools Board of Directors (aka Magnolia Education and Research Foundation Board) and manages the business operations of the Magnolia Public Schools. The organization chart below shows the relationship between the Magnolia Public Schools and the MERF.
Magnolia Public Schools
Organization Chart
Magnolia Public Schools Board of Directors (aka Magnolia Educational and Research Foundation Board)

Magnolia Public Schools Central Office

Chief Executive Officer

Executive Assistant

MPS Chief Academic Officer

MPS Chief Operational Officer

MPS Chief Financial Officer

Project Manager

All Charter School Principals

(12 charter schools under the MPS)

Data and Accountability

This audit was part of the Annual Work Plan of the Office of the Inspector General for fiscal year 2012 and is intended to support the Innovation and Charter Schools Division in monitoring the operational and financial aspects of District Charter Schools.

Objective
Our audit objective was to determine whether the Board of Directors and management of the Magnolia Public Schools Central Office were adhering to the conditions, standards and procedures outlined in its Charter Agreement with the Los Angeles Unified School District 1

(LAUSD or District). For this audit, we reviewed the following areas: Governance Structure Employment Documentation/Qualifications of Staff Admission/Enrollment Requirements Financial Audits Fund Reserves, and Internal Controls

Summary of Key Audit Findings

Areas Requiring Attention: Our audit found that the MSA Schools were not in full compliance with the selected provisions, standards and procedures outlined in their respective Charter Agreements. We also noted that the MSA Schools needed to strengthen their internal control systems and their oversight of fiscal and financial operations. Some of the significant conditions we noted during the audit included: The governing board needed to review its existing governance structure to allow for the increased participation of parents, community members and other parties in the Charter Schools policy decision areas and other school advocacy. The MSA Schools did not maintain all employment documentation in the employee files as prescribed by the California Education Code and the Charter Agreement. The MSA Schools did not maintain all the enrollment documentation required by the written enrollment procedures and by the provisions of the Charter Agreement. Review of the financial statements and accounting records noted: non-disclosure of related party transactions; failure to maintain required fund reserves; failure to appropriately apply accrual basis of accounting; lack of monitoring of cash receipts and deposits process; lack of documentation for disbursements; lack of control over journal entries, and lack of adequate training for the accounting staff. The processes and controls over the bank reconciliation were inadequate. We found one Charter School that dated all reconciliations three days prior to this audit. We also noted that some deposits in transit remained outstanding in bank reconciliations from five months to almost a year.

Conclusion: Our audit noted control weaknesses in governance structure, employment documentation and qualifications of staff, admission/enrollment requirements and various financial control issues managed by the Magnolia Public Schools Central Office at the MSA School sites visited. The information provided in this report should benefit the MSA Charter Schools to significantly improve their internal control system as well as its oversight of fiscal and financial operations. We believe that the Magnolia Public Schools Board of Directors 2

should revisit the provisions of the approved charter petition to preclude potential violations of the Charter Agreement with the District and other provisions of the California Education Code.

Potential Impact
The conditions described above, along with their underlying causes, may have increased the risk of fraud, waste and abuse of the MSA Charter Schools funds that could potentially result from the inability to detect irregularities, improper use of public funds or misappropriation of assets. Also, the questioned costs and questionable accounting practices identified in the course of the audit may have resulted in misstated and inaccurate financial statements of the MSA Charter Schools.

What The Board of Directors of Magnolia Public Schools Should Do Next: Summary of Key Recommendations
We provided the Magnolia Public Schools Board of Directors with eleven recommendations to ensure full compliance with the Charter Agreement and to enhance the current internal controls system. A complete description of these recommendations is included in the body of the report. Some of the more significant recommendations we made included the following: Review the existing school governance structure and consider the increased participation of parents, community members and other parties in the policy decision areas and other school advocacy. Enhance controls over employee qualifications and documentation requirements. Enhance controls over the established enrollment procedures and maintenance of required student records. Ensure that all related party transactions are disclosed in the financial statements, required fund reserve is maintained, cash balances are properly controlled, bank reconciliations are timely completed, proper documentation is maintained for all disbursements, journal entries are adequately supported and in general, the Generally Accepted Accounting Principles (GAAP) are followed for all accounting functions. Establish formal job descriptions for the accounting staff and provide training on a regular basis.

Charter School Comments: The Charter School executive management agreed with all of our findings and stated that they have already taken some corrective actions and plan to take further actions in the future to ensure that OIG recommendations are adequately and timely implemented.

Inspector General Response: Managements response to our audit findings and recommendations indicate an understanding of the issues presented. We consider managements planned actions to be constructive steps towards improving the processes reviewed in this audit.

Scope & Methodology

We conducted this audit in accordance with Generally Accepted Government Auditing Standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. The audit covered the activities for the period from July 1, 2010 through June 30, 2011. In order to address the audit objectives, we performed certain procedures, which included, but were not limited to the following: Reviewed applicable laws and regulations pertaining to charter school operations. Reviewed and examined records to verify compliance with the provisions of the Magnolia Public Schools Charter Agreement with the District. Performed walkthroughs of each audit area with key personnel to obtain an understanding of the current fiscal and financial processes of the Charter School. Reviewed the existing accounting policies and procedures to assess the design and operational effectiveness of internal controls. Examined general ledger transactions, components of the assets and liabilities, audited financial statements, and other related records and reports. Tested statistically selected samples of revenue and expenditure transactions. Assessed the adequacy of the Charter Schools governance structure. Reviewed the employment documentation for compliance with the Charter Agreements and applicable laws. Obtained the enrollment procedures and assess the completeness of enrollment requirements. Assessed the sufficiency of the available fund reserves. During the course of our audit, we also interviewed selected personnel of the MSA Schools and the Magnolia Public Schools Central Office with responsibilities related to our audit objectives. We performed the audit from February 2012 through June 2012.

FINDING AND RECOMMENDATIONS

FINDING A:

Compliance with Charter Agreement For the Board of Directors, Magnolia Public Schools

BACKGROUND
The Magnolia Educational and Research Foundation (MERF) is a non-profit organization founded in 1997 (under the name Dialog Foundation) and was granted a 501(c) (3) tax-exempt status by the Internal Revenue Service in 1998. The first charter school, Magnolia Science Academy was established in 2002. Since then, the MERF has established 12 charter schools (aka Magnolia Public Schools) in the State of California. The MERF is ultimately in charge and oversees the operations of the 12 Magnolia Public Schools. The Los Angeles Unified School District (LAUSD or District) has currently authorized the operation of eight charter schools (MSA-1, MSA-2, MSA-3, MSA-4, MSA-5, MSA-6, MSA-7, and MSA-8) while the other four schools operate outside of Los Angeles County. The MSA-San Diego was authorized by the San Diego Unified School District, the MSA-Santa Clara was authorized by the Santa Clara County Office of Education, and both the Pacific Technology School (PTS)-Santa Ana (Orange County) and PTS-Orange Vale (El Dorado County) were authorized by the State Board of Education. The MERFs educational philosophy and mission are to serve students in grades 6-12 by: (1) Preparing students to become responsible, educated citizens who have the skills and understanding to participate and work productively in a diverse, multicultural, globally oriented environment; (2) Providing a sound educational plan with emphasis on math, science and technology; and (3) Providing a rigorous, innovative, and challenging enhanced curriculum with a focus on preparing students to attend the universities of their choice. The student population represents the demographics of the local communities where the students reside, which are primarily in the metropolitan areas of Los Angeles, and other metropolitan areas throughout the state. MERF specifically targets low-achieving students, English language learners, and students coming from socio-economically disadvantaged families. Organizational Structure The Magnolia Public Schools Board of Directors (aka Magnolia Educational and Research Foundation Board) is responsible for establishing the broad policies to implement the mission of the Magnolia Educational and Research Foundation for the Magnolia Public Schools. The 5

Board is also responsible for ensuring that staff carry out the school programs in compliance with Board policy and the applicable state and federal laws and regulations and for making sound financial decisions that are in the best interest of the public. In addition, Board members appoint and evaluate the performance of the Chief Executive Officer. The Chief Executive Officer (CEO) and management are responsible for carrying out the Boards policy decisions and for managing the day-to-day school operations of the Magnolia Public Schools. They are to establish and maintain an effective internal control system to ensure that each charter school meets appropriate goals and objectives, safeguards public assets, follows laws and regulations and reports reliable financial information. Exhibit 11 below shows the organization chart of the Magnolia Public Schools.
Exhibit 1 Magnolia Public Schools Organization Chart
Magnolia Public School Board of Directors (aka Magnolia Educational and Research Foundation Board)

MPS Central Office

Chief Executive Officer

Executive Assistant

Chief Academic Officer

Chief Operational Officer

Chief Financial Officer

Project Manager

All Charter School Principals

(12 charter schools under the MPS)

Data and Accountability

The Board appointed the Magnolia Public Schools Central Office to execute the decisions and policies set by the Board and to manage the business operations of the Magnolia Public Schools. Currently, the headquarters of the Magnolia Public Schools Central Office is located at 13950 Milton Avenue, Westminster, CA 92683. The Magnolia Public Schools Central Office receives annual fees for the services provided to the schools which include, but are not limited to (i) Overseeing Magnolia Public Schools operations to ensure compliance with the charter agreements, (ii) Curriculum development, (iii) Hiring school principals, (iv) Payroll, (v) Purchasing, (vi) Budgeting, (vii) Annual audit, (viii) Community outreach, and (ix) Public relations.

Magnolia Foundation WASC Wiki Site : https://sites.google.com/a/magnoliafoundation.org/msa2wasc/

DISCUSSION
This section discusses the following areas: Governance Structure Employment Documentation/Qualifications of Staff Admission/Enrollment Requirements Financial Audit Fund Reserves Basis of Accounting

Governance Structure
The governing board needed to review its existing governance structure to allow for the increased participation of parents, community members and other parties in the Charter Schools policy decision areas and other school advocacy. The California Code of Regulations states that the required elements of the charter petition should include The governance structure of the school, including, but not limited to, the process to be followed by the school to ensure parental involvement in supporting the school's effort on behalf of the school's pupils, as required by Education Code section 47605(b) (5)(D). The Charter Agreement states that the Board of Directors shall consist of a minimum of three (3) and a maximum of twenty one (21) voting members. In addition, the chartering agency is entitled to have a representative on the Board as an additional non-voting member, pursuant to the Education Code 47604(b). The Board is ultimately in charge of the Charter Schools operation and governance. The Magnolia Public Schools Central Office was appointed by the Board to be responsible for the execution on behalf of the Board. The Chief Executive Officer (CEO) is hired, supervised and evaluated by the Board of Directors. The CEO and the management are responsible for carrying out the Boards policy decisions and for managing the school operations. They are to establish and maintain an effective internal control system, ensuring that the Charter Schools meet appropriate goals and objectives, safeguards public assets, follows laws and regulations and reports reliable financial information. The Magnolia Public Schools Central Office, headed by the CEO, manages all the business activities of the Charter Schools and is responsible for the (i) curriculum development, (ii) hiring of principals, (iii) financial operations such as budgeting, payroll, procurement and accounting, and (iii) ensuring compliance with the charter agreement and applicable state and federal laws and regulations. A School Site Council (the Council) formed at each school is accountable to the Magnolia Public Schools Central Office for the local school operations. The Council is mainly an advisory body holding the school responsible for its operations. The Council consists of:

The school Principal 1 Teacher representative elected by the faculty 1 Parent representative elected by the Parent Club 1 Student representative elected by the Student Council 1 Community representative appointed by the Magnolia Public Schools Central Office 1 Representative from the Chartering Agency.

The Council also makes policies for issues unique to the school. The school Principal will communicate these policies to the Magnolia Public Schools Central Office. Test Work Performed We performed the following procedures to determine the adequacy of the Charter Schools governance structure: (1) Assessed the Boards composition and qualifications in terms of the Charter Agreement, (2) Reviewed Magnolia Public School articles of incorporation and bylaws, (3) Evaluated the organizations structure, (4) Reviewed the Minutes of the Meeting of the Board of Directors, (5) Assessed the operating principles, values, and philosophy of the school, (6) Evaluated the Charters requirements for School Site Council (Council), and (7) Reviewed the minutes of the Council. The Magnolia Public Schools Board of Directors (aka Magnolia Educational and Research Foundation Board), governs and exercises oversight over the school and fiscal operations of all the twelve Magnolia Public Schools. The Charter Agreements state that Board meetings are to be held at least four times a year. We noted that the Board held the meetings every month in FY 2010 and every two months during FY 2011, wherein the majority of the meetings were convened in the evening. Based on our review of the Charter Agreements, Minutes of the Meetings, and Board qualifications, we determined the following: The Board was comprised of seven (7) voting members, including one parent representative. Although there were eight District authorized charter schools, the parent member in the Board came from the lone charter school operating in the Orange County. The Charter Agreements specified that the Council is mainly an advisory body which shall consist of six representatives. We reviewed the minutes of the Council meeting and noted that the Council met once or twice in a year. We also observed that some of the Council meetings were not well represented by the parents and other council members.

These conditions occurred because the governing Board appeared to be not so rigorous in sharing the governance responsibility with the majority of the parents/community members.

The failure to include appropriate members of the governing Board and school committees may have resulted in: A lack of awareness for parents and community representatives especially involving decisions of the charter school regarding students issues. Perceived unethical selection of the members of the Board of Directors. Diminished public trust for lack of organizational transparency. Non-compliance with the Education Code and the approved Charter Petition.

We discuss the actions needed to correct these conditions in Recommendation A-1.

Employment Documentation/Qualifications of Staff

The MSA Schools did not maintain all employment documentation in the employee files as required by the California Education Code and the Charter Agreements. The California Education Code, Sections 442372 , 47605 (5) (E) and (F)3 and 494064 and the Charter Agreement require that school employees furnish the school with the following documents prior to the first day of work: Medical clearance including proof of medical exam and tuberculosis (TB) testing. Fingerprinting and the service fee to the Department of Justice for a criminal record check. Applicants will be required to provide a full disclosure statement regarding prior criminal record. Documents establishing legal status, and current copies of all teacher certificates.

Per Charter Agreement, the documents listed above should be kept on-site and be ready for inspection. Best practices suggest that a good employee file system helps maintain the organizational structure, as well as a protection for both the employer and the employee. By compiling the necessary and complete employee documentation, the employer may (i) make decisions and take actions based on the organizations personnel policies, (ii) establish defense against legal action/s brought by employee/s, (iii) be prepared for a government audit related to tax or immigration issues, and (iv) comply with applicable laws and regulations Test Work Performed We obtained the list of MSA School employees and examined the personnel files to determine whether the folders contained the required employment documentation. Table 1 below summarizes the missing documents at each school site.
2 3

California Education Code, Section 44237, Part 25 - Employees, Chapter 2/Article 2 - Teacher Credentialing Ibid, Section 47605 (5) (E) and (F), Part 26.8 - Charter Schools, Chapter 2 - Establishment of Charter Schools 4 Ibid, Section 49406 (a) and (b), Part 27-Pupils, Chapter 9 Pupil and Personnel Health

Table 1 Missing Employment Documentation MSA-1 (out of 23 employees) 5 2 1 MSA-2 (out of 20 employees) 1 4 MSA-3 (out of 22 employees) 3 1 Total Number of Exceptions 9 7 1

Type of Documents TB Test/Chest X-ray DOJ Clearance/Fingerprinting Current Teachers Credential

Based on our review of the required documentation, we noted the following conditions: Six employees did not have supporting documentation that TB tests were performed. Also three employees had TB test documentation that was done more than 4 years ago. Three employees did not have a DOJ clearance on file. In addition, the supporting documentation on file showed that four employees were permitted to work before receiving a DOJ clearance. One employee had an expired teachers credential certificate.

We have also observed that other employment forms were not consistently maintained in the personnel file folders, such as the Performance Evaluation Form, Employee Handbook Receipt Form, and the Proof of Child Abuse Awareness Training. According to the CFO, the Magnolia Public Schools Central Office is continuously monitoring the employees up-to-date employment documentation. However, some documents may have been misfiled at the school site or were maintained in separate folders. During the course of the audit, the CFO provided some of the missing TB tests and DOJ clearances. These conditions occurred because (i) the MSA Schools overlooked the requirement to obtain and maintain the necessary employment documentation from new hires and from employees who were currently employed, and (ii) there was inadequate management and control of the employee file system. As a result, the failure to obtain and maintain the necessary employment documentation could (i) increase the potential risk that the MSA Schools and the employees may not be protected should lawsuits arise, and (ii) have compromised the health and safety of the students and employees. We discuss the actions needed to correct these conditions in Recommendation A-2.

Admission/Enrollment Requirements
The MSA Schools did not maintain all the enrollment documentation required by the written enrollment procedures and by the provisions of the Charter Agreements. The admission policy requires the charter schools to admit all students residing in California who wish to attend on a space-available basis. If student applications exceed capacity, priority 10

for admission will be given to siblings of existing students. Then a public lottery is held to select the students to be admitted. In the lottery, all names are drawn and listed in order, separately, for each grade level. A written application is required for each student. Furthermore, the enrollment procedures require the submission of a completed enrollment packet consisting of the following documentation for a student to enroll: Copy of birth certificate Copy of current immunization Proof of TDAP vaccine Proof of residence Pupil Accounting Report (PAR) Official Transcript and Last Report Card Received Copy of Individualized Education Plan, if child has one California Standard Test (CST) scores and California English Language Development Test (CELDT), and Other school registration forms, such as the health history card, emergency card, school permission slip, parent-student compact and emergency treatment form.

Test Work Performed We obtained the written enrollment procedures and the list of enrolled students as of September 2010 from each of the MSA Schools. From the list, we determined the sample size of the students files to be tested using a computer assisted statistical sampling plan. Based on the sampling results, a total of 45 students were selected for detailed testing: 15 out of 496 students from MSA-1, 14 out of 218 students from MSA-2 and 16 out of 249 students from MSA-3. We examined the enrollment documentation to determine whether the charter schools were compliant with the established enrollment policies and procedures. Based on our review, we noted that the MSA Schools did not maintain all the enrollment documentation, as shown in Table 2 below:
Table 2 Missing Enrollment Documentation Missing Enrollment Documents Birth certificate Immunization Records Proof of T-dap Vaccine Proof of residence Health history card School Entrance Medical Record Emergency Treatment Form Emergency Card School Permission Slip Parent-Student Compact MSA-1 (out of 15 students) 2 MSA-2 (out of 14 students) 1 3 4 2 3 4 4 4 4 MSA-3 (out of 16 students) 2 2 2 2 4 4 3 4 2 2 Total Number of Exceptions 3 2 5 6 6 7 7 10 6 6

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These conditions occurred because the MSA Schools failed to obtain and follow-up on the missing documents from the students upon enrollment. As a result of the conditions described above, students may not have been enrolled in accordance with the California Education Code and the health and safety of the students may have been compromised. We discuss the actions needed to correct these conditions in Recommendation A-3.

Financial Audit
The audited financial statements did not adequately disclose the organizational relationship between the MSA Schools and the Magnolia Educational and Research Foundation, including its related party loan transactions. The California Schools Accounting Manual (CSAM) states, Not-for-profit charter schools approved under Education Code Section 47604 that operate as or are operated by a nonprofit public benefit corporation pursuant to Section 501(c) (3) of the Internal Revenue Code typically use the not-for-profit accounting model and the accrual basis of accounting. The authoritative source of GAAP for this model is the Financial Accounting Standards Board (FASB).5 The FASB Accounting Standards Codification (ASC) 850-10-50 contains the disclosure requirements for related party relationships and transactions. Certain relationships, such as parent-subsidiary or investor-investee, may be clearly evident of a related party transaction. Transactions, that because of their nature, may be indicative of the existence of related parties include: i) borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates prevailing at the time of the transaction, and ii) making loans with no scheduled terms for when or how the funds will be repaid. 6 One of the main purposes of audited financial statements is to provide the accountability, accuracy, as well as financial credibility of an organization. The CPA firm is required to include disclosure notes for some financial statement elements. Also, other information is provided when required by specific situations in the interest of full disclosure. As such, the existence of material related party transactions that could affect the financial statements and of common ownership or management control relationships requires disclosure. 7 Test Work Performed We examined the MSA Schools audited financial statements for the years ended June 30, 2010 and June 30, 2011, and noted the following:
5 6

California School Accounting Manual, Procedure 810-1, Charter Schools, March 2008 Generally Accepted Auditing Standards, AU 334.03 Related Party 7 Ibid, AU 334.04

12

The organizational relationship between the Magnolia Educational and Research Foundation and the MSA Schools was not disclosed in the audited financial statements. During the course of the audit, we noted that the MSA Schools bank deposit accounts were under the name of the Magnolia Educational and Research Foundation, as well as the employers name and the identification number on the payroll tax remittances. We were informed by the Chief Financial Officer that the Magnolia Educational and Research Foundation is the legal entity and the parent non-profit organization Doing Business As (DBA) the Magnolia Science Academy. The MSA Schools are considered to be the subsidiaries of the Magnolia Educational and Research Foundation. The Audited Financial Statements of MSA #1 for FY 2011 clearly showed a substantial balance in the Other Assets-Loans Receivable-related party amounting to $322,509. On the contrary, the Cash and cash equivalents had a zero balance. Further analysis of the general ledger and the bank statements revealed that on several occasions, the Magnolia Educational and Research Foundation had borrowed an aggregate total of $397,409 from the MSA#1. During the audit, we were provided with the copy of the Loan Agreement dated 06/30/11 issued by the Magnolia Educational and Research Foundation for the remaining balance of the loan. We noted that there was no definite time of repayment and the loan was interest-free.

Considering that the organizational structure of the MSA Schools is relevant information, the audited financial statements should provide the nature of its relationship with the Magnolia Educational and Research Foundation. For the MSA#1, the related party loan transaction was substantial and may have a material impact on its actual financial position. We believe that the information should have been disclosed in the Notes to Financial Statements in the interest of full disclosure and in compliance with Generally Accepted Accounting Principles. These conditions occurred because the Magnolia Public Schools Central Office and the independent external auditors overlooked the full disclosure of the organizational relationship between the MSA Schools and the Magnolia Educational and Research Foundation, including its related party loan transactions, in the Audited Financial Statements. As a result, the failure to appropriately disclose pertinent and material information in the audited financial statements may be perceived as intentional conduct to omit relevant financial information. Additionally, the principle of full disclosure under the Generally Accepted Accounting Principle may not have been followed. We discuss the actions needed to correct these conditions in Recommendation A-4.

13

Fund Reserves
The MSA Schools did not meet the minimum unrestricted reserves required by the California Code of Regulations. The California Code of Regulations, Section 15450 states, Available reserves for any of the budget year or two subsequent fiscal years are not less than the following percentages or amounts as applied to total expenditures and other financing uses: a) the greater of 5% or $55,000 for districts with 0-300 ADA b) the greater of 4% or $55,000 for districts with 301-1,000 ADA. 8 Additionally, the Innovation and Charter Schools Division provides that the charter school will at all times maintain a fund balance (reserve) of its expenditures as required by Section 15450, Title 5 of the California Code of Regulations. Currently, the required reserve is 5% of total operational expenditures.9 The Charter School Annual Performance Evaluation criteria indicates that an existing school shall have an ending cash reserve that exceeds 4% or more of prior audited expenses. Test Work Performed We reviewed the cash balances reflected in the audited financial statements and compared the cash balances with the bank statements to determine the available reserve of the MSA Schools. We noted that as of June 30, 2011, the MSA#2 did not have sufficient cash reserve while the MSA#1 and MSA# 3 had zero cash balances in the bank. Based on our analysis, the MSA Schools had deficit fund reserves, as shown in Table 3 below:
Table 3 Analysis of Fund Reserve Description Total Expenditures for FY 2011 Average Daily Attendance (ADA) Required Percentage of Available Reserve
(based on ADA)

MSA #1 $3,937,956 475 4% $157,518 $0 ($157,518)

MSA #2 $1,821,234 221 5% $91,062 $56,802 ($34,260)

MSA #3 $1,746,770 245 5% $87,339 $0 ($87,339)

Minimum Reserve Requirement

(Total Expenditures x % of reserve)

Available Reserve (Cash and cash equivalents)

(based on the Audited Financial Statements for FY 2011)

Excess/(Deficient) Fund Reserve

8
9

California Code of Regulations, Title 5, Division 1, Chapter 14, Subchapter 8, Article 1, Section 15450 Innovation and Charter Schools Division, Boiler Plate for Charter School Petitions, 2008

14

It appeared that the MSA Schools did not retain a sufficient amount of fund reserves for the incoming fiscal year 2012. Particularly, the MSA #1 disbursed a considerable amount of related party loan payments to the Magnolia Educational and Research Foundation without setting aside a fund reserve for the school. As of June 30, 2011, the MSA #1 had an outstanding loans receivable from the Magnolia Educational and Research Foundation amounting to $322, 509. These conditions occurred because: i) There was a lack of effective policy and procedures to project and maintain adequate cash balances throughout the year, ii) The Magnolia Public Schools Board and the executive management were not conscientious in addressing the MSA Schools budgetary objectives including funding priorities, maintenance of fund reserves and cash balances, and incurrence of debt. iii) The MSA Schools did not receive all the revenues for fiscal year 2011. As a result, the failure to maintain the required fund reserve may have endangered the financial stability of the schools against unforeseen revenue shortfalls or unexpected expenditures. We discuss the actions needed to correct these conditions in Recommendation A-5.

Basis of Accounting
The Magnolia Public Schools Central Office did not apply the appropriate accrual basis of accounting in recording and reporting the financial transactions of the MSA Schools. The California School Accounting Manual (CSAM) provides guidance on Generally Accepted Accounting Principles (GAAP) for all local educational agencies (LEAs), as well as specific guidance for LEAs in California. Section 15071 of Title 5 of the California Code of Regulations requires that charter schools follow the guidelines in CSAM, to the extent the guidelines apply, for reporting of financial data.10 The term Generally Accepted Accounting Principles refers to the standards, rules, and procedures that serve as the norm for the fair presentation of financial statements. Conformity with GAAP is essential for consistency and comparability in financial reporting. 11 The Charter Agreement of the Charter Schools states, The accounting procedures must follow the GAAP. The Magnolia Public Schools Central Office will identify staff responsible for financial administrative functions and the qualifications of staff assigned to these functions, and will also provide assurance that the accounting systems adopted would adhere to GAAP and describe the process of internal controls.12
10 11

California School Accounting Manual, Procedure 810-1, March 2008 California School Accounting Manual, Procedure 101-1, July 2005 12 Magnolia Science Academy Charter Agreement, Additional Requirements 2: Financial and Budget Matters-Fiscal Management, January 31, 2007

15

The written financial policies and procedures manual also states, The Magnolia Public Schools Central Office is responsible for the financial management of the school. The Principal/CFO must ensure that all provisions of the manual and local board policies and procedures are complied with, that all accounting records are maintained accurately, and that all financial reports are prepared and submitted in a timely manner. MSA/PTS schools are to maintain its accounting records on the accrual basis of accounting, modified at year end to reflect any receivables or payables that may exist. Revenues and expenditures are to be recognized when the transaction has occurred. 13 As such, revenues and expenses are recorded using the accrual basis of accounting and requires that revenues are recognized in the accounting period in which they are earned and expenses are recognized in the period in which goods or services are received or incurred. Test Work Performed We reviewed the procedures on how the Magnolia Public Schools Central Office processed, reported and maintained the financial transactions of the MSA Schools at the end of the accounting period. During our audit, we noted the following conditions: The Magnolia Public Schools Central Office was unable to provide supporting schedules or analysis to back-up the accrued revenues reflected in the general ledger as of year-end of FY 2011. Some subsequent disbursements, which pertained to expenditures incurred in FY 2010, were not identified in the accounts payable. Based on our review of selected samples of expenditures, we found that some expenses were not reported in the appropriate accounting period when the goods or services were incurred. The expenses were recognized and accounted for in FY 2011 when the payments were made to the vendors. The Table 4 below shows the details of the mismatched expenses.

13 Magnolia Foundation Schools Academic and Financial Policies and Procedures, page 43, per copy provided to the internal

auditor on February 2012

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Table 4 Details of Improperly Matched Expenses July 1, 2010 to June 30, 2011
(Based on the review of randomly selected samples of disbursements)

Name of School MSA-1

MSA-2

MSA-3

Period the Expenses were Incurred Books and Supplies 09/17/09 Central Office Fees for June 2010 06/30/10 Food Expenses-April, May & June 2010 04/01/10 to 06/30/10 Liability Insurance -March 2010 to June 2010 03/01/10 Total Amount of Expenses School Information System Software Fee 06/01/10 Building Rental and utilities 06/01/10 Other Textbooks 06/04/10 Professional/Consulting Services 06/01/10 Central Office Fees-April 2010 through June 2010 04/01/10 to 06/30/10 Food Expenses-December 2009 through 12/31/09 to March 2010 03/31/10 Food Expenses-April 2010 through 04/30/10 to June 2010 06/30/10 Total Amount of Expenses Health Ins. Premium-April, May & June 2010 04/01/10 to 06/30/10 Special Education Cost for March 2010 03/31/10 Special Education Cost for April 2010 04/30/10 Total Amount of Expenses Nature of Expenses

Amount $16,298.74 22,560.25 45,905.16 7,753.42 $92,517.57 804.95 20.244.24 802.85 1,500.00 24,317.31 17,953.18 15,496.48 $81,119.01 30,000.00 15,951.26 16,038.46 $61,989.72

Date Recorded as Expenses 07/21/10 08/02/10 09/15/10 10/19/10 07/20/10 08/15/10 08/15/10 08/25/10 10/15/10 09/12/10 02/17/11

07/08/10 10/11/10 11/06/10

These conditions occurred because (i) the process of identifying and recording period end accounts payable was inadequate, (ii) the Magnolia Public Schools Central Office did not fully observe the accrual basis of accounting as stated in the written policies and procedures, and (iii) the matching principle under GAAP was overlooked or ignored. As a result, the failure to report the obligations on its financial statements understated the organizations liabilities and expenses and increased the risk that the financial information was inaccurate and unreliable. We discuss the actions needed to correct these conditions in Recommendation A-6.

17

RECOMMENDATIONS AND COMMENTS

Recommendation A-1: The Board of Directors of the Magnolia Public Schools is encouraged to review its existing governance structure to allow for the increased participation of parents, community members and other parties in the policy decision areas and other school advocacy. By doing so, this may increase the public trust that the organization follows the laws, behaves in an ethical manner, and does not waste the resources trusted in its care. Charter School Comments: The management agreed with our recommendation and stated that the Board of Directors will review its existing governance structure to allow for the increased participation of parents, community members and other parties in the policy decision areas and other school advocacy. It will be discussed during the August, 2012 board meeting and appropriate actions will be taken in October, 2012 board meeting.

Recommendation A-2: The Board of Directors of Magnolia Public Schools should: Remind the Chief Executive Officer to instruct the Principals to ensure that individuals employed by the school meet the required qualifications and that all required and necessary employment documentation is maintained in the employee files. Instruct the Chief Executive Officer to improve the oversight over the employee files system.

Charter School Comments: The management agreed with our recommendation. Following the audit, MPS management implemented additional controls to ensure that individuals employed by the schools met the required qualifications and that all required and necessary employment documentation is maintained in the employee files. In addition, MPS management has created Chief Operating Officer position to enhance the internal control and further improve the oversight over the employee files system. However, we would like to note that all MPS employees are asked to provide DOJ clearances, TB test results and teaching credentials (for teachers). MPS will make sure that all required employment documentations and qualifications are met prior to employment. There may have been few instances where DOJ clearances are misplaced and kept in the MPSs central office or TB results are expired which were addressed immediately following the audit.

Recommendation A-3: The Board of Directors of Magnolia Public Schools should: Direct the Chief Executive Officer in coordination with the Chief Academic Officer, to remind the Principals to ensure that established enrollment procedures are observed and that all students attending the Charter Schools have all the necessary and complete documentation that are reviewed and maintained on file.

18

Charter School Comments: The management agreed with our recommendation and stated that the Board of Directors will direct the Chief Executive Officer, in coordination with the Chief Operating Officer, to remind the Principals to ensure that established enrollment procedures are observed and that all students attending the Charter Schools have all the necessary and complete documentation that are reviewed and maintained on file. The target date of implementation is August 31, 2012.

Recommendation A-4: The Board of Directors of Magnolia Public Schools should: Direct the Chief Executive Officer, in coordination with the Chief Financial Officer, to disclose in the audited financial statements the relevant information about the organizational relationship between the Charter Schools and the Magnolia Educational and Research Foundation including the related party transactions.

Charter School Comments: The management agreed with our recommendation and stated that the Board of Directors will direct the Chief Executive Officer, in coordination with the Chief Financial Officer, to disclose in the audited financial statements the relevant information about the organizational relationship between the Charter Schools and the MERF, including the related party transactions. The target date of implementation is August 31, 2012.

Recommendation A-5: The Board of Directors of Magnolia Public Schools should: Direct the Chief Executive Officer in coordination with the Chief Financial Officer to ensure that the fund balance/reserve will be maintained at the required reserve level throughout the year. Instruct the Chief Executive Officer to establish effective policy and procedures to monitor and perform regular cash projections to ensure that cash balances were accurate, available and the funds are not overspent.

Charter School Comments: The management agreed with our recommendation and stated that the Board of Directors will direct the Chief Executive Officer, in coordination with the Chief Financial Officer, to ensure that the fund balance/reserve will be maintained at the required reserve level. In addition, the Board of Directors will instruct the Chief Executive Officer to enhance policies and procedures to better monitor and perform regular cash projections to ensure that cash balances were accurate, available and the funds are not overspent. The target date of implementation is September 30, 2012.

Recommendation A-6: The Board of Directors of Magnolia Public Schools should: Direct the Chief Executive Officer, in coordination with the Chief Financial Officer, to: o Be diligent in implementing the Generally Accepted Accounting Principles in recording and reporting the financial transactions of the Charter Schools. 19

o Provide adequate oversight to ensure that the Charter Schools shall comply with the accounting procedures as stated in the approved Charter Agreement, the written policies and procedures and as required by law. Charter School Comments: The management agreed with our recommendations. Following the audit, MPS management implemented additional controls over accounting procedures and has taken number of actions to avoid any possible incompliance with generally accepted accounting principles in recording and reporting financial transactions of the Charter Schools. In addition, the Board will improve the oversight to ensure that the Charter Schools shall fully comply with the accounting procedures as stated in the approved Charter Agreement, the written policies and procedures and as required by law. The target date of implementation is August 31, 2012.

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FINDING AND RECOMMENDATIONS FINDING B:

Internal Controls For the Board of Directors, Magnolia Public Schools

BACKGROUND
Control Activities are the policies, procedures, techniques, and mechanisms that enforce managements directives. Transactions and other significant events should be authorized and executed only by persons acting within the scope of their authority. Authorizations should be clearly communicated to managers and employees. 14 Internal control and all transactions and other significant events need to be clearly documented, and the documentation should be readily available for examination. All documentation and records should be properly managed and maintained. 15 We obtained a copy of the Magnolia Foundation Schools Academic and Financial Policies and Procedures manual to determine whether the internal control system of the Charter Schools is in place. The financial policies and procedures were designed to provide guidance to the Magnolia Public Schools to systematically record, summarize, and report all the financial transactions of the organization. The manual specified that The school Central Office is responsible for the financial management of the school. The Principal/CFO must ensure that all provisions of the manual and local board policies and procedures are complied with, that all accounting records are maintained accurately, and that all financial reports are prepared and submitted in a timely manner. According to the CFO, the policies and procedures manual was created in 2008. We also obtained documentation supporting the activities performed and the transactions processed by the Magnolia Public Schools Central Office and the school staff to determine whether the policies and procedures specified in the manual were followed in practice.

14

Standards for Internal Control in the Federal Government, issued by the United States General Accounting Office, November 1999, p.14 15 Ibid, p.15

21

DISCUSSION
This section discusses the following areas: Cash Receipts and Deposits Expenditures/Disbursements Bank Reconciliation Statements General Journal Entries Competency of Staff

Cash Receipts and Bank Deposits

The MSA Schools did not adequately monitor the cash receipts and deposits process. Several accounting errors and lack of supporting documentation were noted. The written accounting policies and procedures manual states, All funds collected must be deposited intact in a bank account. To minimize the risk of loss or theft, it is recommended that bank deposits be made upon receipt but no later than seven days. Each bank deposit slip must contain the following information: i) the name of the school, ii) the bank account number, iii) the date the deposit slip was completed, iv) the total amount of cash included in the deposit, iv) the total amount of the deposit. Receipts should be adequately safeguarded and properly recorded on a timely basis using the account codes prescribed in the Chart of Accounts A validated bank deposit receipt should be retained for each bank deposit... As part of the procedure, the Accountant counts the cash receipts and reviews the supporting documentation, Cash Receipts Summary, and deposit slip, then, indicates review on the cash receipts summary. The Accountant makes the deposits and files the supporting documentation, Cash Receipt Summary and validated bank deposit receipt by deposit date.

Test Work Performed We reviewed the bank statements, deposit slips, general ledger and the audited financial statements to determine whether the amounts recorded as receipts represent valid and authorized transactions, were classified in the correct account, were accurately reported in the proper accounting period, and were properly presented and disclosed in the financial statements. During the audit, we noted the following conditions, as summarized in Table 5 below:

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Table 5 Summary of Exceptions Cash Receipts and Bank Deposits July 1, 2010 to June 30, 2011 Conditions Noted Inadequate or missing documentation. Some deposits were recorded in the general ledger without the supporting documents or source records (i.e. deposit slips, photocopies of warrants, Cash Receipts Summary, etc.) MSA-1 (85 samples tested) MSA-2 (69 samples tested) MSA-3 (78 samples tested) Double posting of deposit. The deposit was recorded twice in the general ledger on 07/27/10. This amount has remained a reconciling item as deposit in transit in the bank reconciliation statement as of 06/30/11. MSA-2 Incorrect accounting entries for bounced checks. The payments returned by the bank due to No Sufficient Funds (NSF) were credited to the revenue account instead of voiding the previously recorded bill payments. MSA-1 MSA-2 Deposit transactions were not recorded in the proper accounting period. Some deposits received in FY 2011 were not recorded in the general ledger. Further analysis revealed that these deposits were for accrued revenues that were recorded as Cash in Bank on 06/30/10 even though the funds had not been received. The accrued revenues should have been recorded as Accounts Receivable. MSA-1 MSA-2 MSA-3 Lack of review and approval of deposit transactions. There was no clear procedure for the review, authorization and approval of the cash receipts and deposits prior to recording to the general ledger. MSA-1 MSA-2 MSA-3 Number of Exceptions % vs. Total Samples Amount

42 44 38

49% 64% 49%

$1,291,607.81 977,354.91 390,552.04

1%

$23,665.69

5 2

6% 5%

$13,359.90 60,090.34

4 2 1

5% 3% 1%

$488,968.20 115,059.82 32,643.53

83 53 73

98% 77% 94%

$4,024,384.53 1,439,540.58 1,508,450.33

These conditions occurred because (i) the Magnolia Public Schools Central Office improperly recorded some deposits in the wrong accounting period and account classification, (ii) the written policies and procedures were inadequate to implement effective controls over complete and accurate documentation of the cash receipts and deposits, and (iii) there was lack of adequate oversight in recording and reporting the actual financial transactions of the MSA Schools. 23

As a result, there was an increased risk that (i) the cash reported in the audited financial statements was inaccurate; (ii) the financial information was unreliable and inaccurate, and (iii) the reliability of management oversight is questionable. We discuss the actions needed to correct these conditions in Recommendation B-1.

Expenditures/Disbursements
The expenditures/disbursements were not adequately documented to support payments for goods or services and were not properly controlled. The written accounting policies and procedures manual states, All disbursements must be made by check or EFT. The check must be payable to the individual or vendor to whom the payment is being made. Every check and check stub must be completely filled out at the time the check is issued. The following procedures should be implemented to comply with statutory requirements and maintain adequate internal control over disbursements. 1) Purchase orders should be prepared for all school disbursements except for exempted items such as salaries and related costs, utilities, or where a contract exists. 2) Disbursements from authorized bank accounts should be made with numbered checks. 3) Unused checks should be physically safeguarded and access to them limited to authorized personnel. California School Accounting Manual (CSAM) is the main guide to identify the correct classification and listing of categories in the chart of accounts. Chart of Accounts is the list of accounts used to record financial transactions including processing income and expenditures, processing asset purchases, recording loans or loan payments, etc. Expenditures are the regular payments from the school account that appropriate expense items are used. To process any expenditure, the following items should be filed: i) Proper invoice ii) Approval for the payment. Test Work Performed We reviewed the disbursements recorded in the general ledger for the period July 1, 2010 through June 30, 2011 for each selected MSA School. We used statistical sampling to determine the number of cash disbursements to be analyzed for testing: 46 samples out of 420 disbursements for MSA-1, 46 out of 282 disbursements for MSA-2, and 43 out of 244 disbursements for MSA-3.We determined whether the amounts recorded were valid and authorized transactions, were classified in the correct account, and were supported by sufficient documentation. During our review, we noted the following conditions, as summarized in Table 6 below:

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Table 6 Summary of Exceptions Expenditures/Disbursements July 1, 2010 to June 30, 2011 Conditions Noted Incomplete or missing documentation. Supporting documentation such as purchase orders, invoices, and receipts were not properly maintained. Some payments were supported by photocopies of vendor invoices or copy of electronic mail from the CFO. MSA-1 (46 samples tested) MSA-2 (46 samples tested) MSA-3 (43 samples tested) Lack of proper review and approval. Some payments did not indicate the appropriate review and approval of authorized signatories. There was only one signatory who approved the payments and signed the checks. MSA-1 MSA-2 MSA-3 Incorrect Account Code Used. Some disbursements were not properly coded and classified in accordance with the California School Accounting Manual (CSAM) and the established chart of accounts. MSA-1 MSA-2 MSA-3 Inadequate control of paid documents. Majority of the invoices and supporting documentation were not effectively identified with stamped PAID to prevent duplicate payments. MSA-1* MSA-2 MSA-3 *In four instances, the MSA#1 made double payments to
vendors totaling to $43,565.18. The payments were improperly supported by duplicate invoices or emails.

No. of Exceptions

% vs. Total Samples

Total Amount

8 13 19

17% 28% 44%

$184,201.83 58,127.16 90,402.61

9 24 22

20% 52% 51%

$109,741.81 126,640.71 150,535.74

11 8 8

24% 17% 19%

$74,948.58 66,864.49 13,284.35

33 31 28

72% 67% 65%

$334,312.24 135,619.37 191,242.12

We also noted that there was no clear policy and procedure for payments processed through the wire transfer or Electronic Fund Transfer (EFT). The supporting documentation or the detailed explanation as to the nature of the payments was deficient. In addition, there was a lack of appropriate review and approval of the authorized signatories. These conditions occurred because (i) the written policies and procedures were inadequate to implement the effective processes and controls over the expenditures and disbursements, and (ii) there was a lack of management oversight to ensure that disbursements were valid, documented, accurately prepared, properly classified and authorized for payment in accordance with the written policy and procedures and good business practices. 25

As a result, there was an increased risk of inappropriate or unauthorized expenditures to remain undetected and a potential risk of fraud, abuse and misuse of public funds. We discuss the actions needed to correct these conditions in Recommendation B-2.

Reconciliation of Bank Statements

The processes and controls over the bank reconciliation were inadequate to ensure that the funds of the organization were fully accounted for and that financial records were accurate and reliable. We found one Charter School that dated all reconciliations three days prior to this audit. We also noted that some deposits in transit remained outstanding in bank reconciliations from five months to almost a year. The written accounting policies and procedures manual states Every bank account must be reconciled monthly as soon as possible after the bank statements are received. Any differences noted between the balance reflected in the schools checkbook and the bank statement must be resolved immediately. After the bank reconciliations are completed, the bank statements are to be signed by Accounting Manager.16 Good business practices suggest that reconciliations, verifications and analytical review of financial records should be performed. Reconciliations involve the comparison of two sets of accounting records. For instance, the cash balances carried in the accounting records should be reconciled to bank statements. Amounts reported in the general ledger should be reconciled to the subsidiary ledgers. Test Work Performed We reviewed all the monthly bank reconciliation statements for the FY 2011 to verify whether the bank statements were prepared timely. We also verified whether the bank statements and the general ledger balances reconciled. Based on our examination of the bank reconciliation statements provided by the Magnolia Public Schools Central Office staff, we noted the following findings and observations: For MSA#1 and MSA #2, the majority of the bank reconciliation statements were dated between three to six months after the end of the month. For MSA #3, all the reconciliation statements were dated three days prior to the start of this audit. As such, there was no assurance whether the bank account information provided to the auditors were the same as that provided to the independent CPA firm. The cash balances in the bank statements as compared to the general ledger did not reconcile, as shown in Table 7 below.

16

Magnolia Foundation Schools Academic and Financial Policies and Procedures, page 46, as of February 2012

26

Table 7 Number of Unreconciled Cash Balances Bank Reconciliations Statements vs. General Ledger As of end of June 30, 2011 Name of Charter School MSA #1 MSA #2 MSA #3 * Number of Instances over the 12- month period 12 10 0 Percentage of Occurrence 100% 83% N/A

* The bank reconciliation statements for MSA #3 were prepared three days prior to this audit, therefore, the integrity of the information was uncertain.

Some deposits-in-transit could not be traced to the subsequent bank statements, as shown in the table below. Deposits-in-transit are funds recorded in the general ledger, and deposited to the banks, that have not yet been posted by the banks. These deposits are reflected in the general ledger, even if it may take the bank a few days to process the deposits. As of June 30, 2011, we noted that some deposits in transit, as shown in Table 8 below, had remained outstanding in bank reconciliations for a period of five months to almost a year. In addition, there was no supporting documentation or explanation to establish the nature of the deposit transactions.
Table 8 List of Outstanding Deposits-in-Transit As of end of June 30, 2011

Amount of Date when deposits were Number of Bank Reconciliation Deposits-ininitially reflected in the months Reviewed By Transit reconciliation statements outstanding $ 1,955 12/31/10 6 Accounting Manager 3,282.85 01/31/11 5 Accounting Manager 16,874.94 01/31/11 5 Accounting Manager Total $22,112.79 MSA #2 $ 490.00 07/31/10 11 Accounting Manager 76,091.00 07/31/10 11 Accounting Manager 23,665.69 07/31/10 11 Accounting Manager Total $100,246.69 MSA #3* N/A * All the bank reconciliation statements for MSA #3 were prepared three days prior to this audit, therefore, the integrity of the information was uncertain.

Name of Charter School MSA #1

Some check payments dated 12 months and over were consistently carried forward in the bank reconciliation statements as outstanding checks, as shown in the Table 9 below. Apparently, there was no indication of a periodic inquiry or investigation to determine why these checks remained as reconciling items in the bank reconciliation statements, even after a considerable period of time. 27

Table 9 List of Stale-dated/Outstanding Checks As of end of June 30, 2011 Name of Charter School MSA #1 Check Issue Date Check Number Amount of Check $ 303.80 500.00 150.00 620.00 514.25 370.96 636.55 1,955.00 $ 5,050.56 1,779.76 1,555.59 307.37 190.00 87.00 105.00 500.00 100.00 17.99 27,256.45 $31,899.16 29.53 1,250.00 50.00 76.00 169.00 500.00 820.00 0.26 $2,894.79 Number of months outstanding 15 14 14 14 14 14 13 13 34 34 33 20 20 19 14 11 11 11 29 25 21 20 14 14 13 13

MSA #2

MSA #3

4/27/2010 5375 5/5/2010 5382 5/14/2010 5385 5/17/2010 5418 5/17/2010 5414 5/17/2010 5415 6/11/2010 5455 6/30/2010 5753 Total Amount 8/29/2008 GL# 13 8/29/2008 GL #14 9/4/2008 20043 12/9/2009 20537 12/9/2009 20536 1/12/2010 20585 5/5/2010 20567 7/20/2010 20720 7/20/2010 20715 7/31/2010 EFT Total Amount 2/5/2009 30200 6/22/2009 30329 10/15/2009 30397 11/2/2009 30399 4/30/2010 DB 5/5/2010 30492 6/29/2010 30512 6/30/2010 Total Amount

These conditions occurred because (i) there was a lack of effective policies and procedures for the bank reconciliation process, (ii) the reconciling items such as, deposits in transit and outstanding checks were not appropriately resolved by the Magnolia Public Schools Central Office accounting staff in a timely manner, and (iii) there was a lack of management oversight over the bank reconciliations process resulting in inaccurate reconciliation statements being signed off by the Accounting Manager in numerous cases. As a result, there was an increased risk of misstated financial reports and undetected loss of assets and a higher risk of fraud. We discuss the actions needed to correct these conditions in Recommendation B-3.

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General Journal Entry

The Magnolia Public Schools Central Office did not have effective processes and controls over the journal accounting entries recorded in the general ledger. The written accounting policies and procedures manual states, Each posting must include the following: the date of the transaction; receipt or check number listed in numeric order, name of payer or payee; and individual account(s) for which the collection or disbursement was made. A cash control/balance column must be maintained to reflect the cash balance available at any time in the fund. If errors are found to exist, they must be identified and corrected as soon as possible by using correcting journal entries. Make the necessary journal entries and include a brief explanation of why the adjusting entries are made.17 Best practices suggest that the accounting staff generates a report at month-end from the general ledger system of all journal entries recorded in the period. The report will be reviewed and approved by a supervisory level employee who does not have access to record transactions in the system. Test Work Performed We reviewed the journal entries recorded in the general ledger of the MSA Schools and selected the journal entries for testing. We reviewed the nature of the journal entry transactions and determined the completeness of documentation. Based on our review, we noted the following: The journal entries did not have the underlying evidence and documentation to support the entries or a clear description explaining the nature of the transactions. The Magnolia Public Schools Central Office staff could not provide a copy of the General Journal Entry Report as of the end of the accounting period. According to the Finance Manager, the Magnolia Public Schools Central Office was not creating periodic reports of journal entries recorded in the general ledger since the posted transactions were accessible in the accounting system. The Magnolia Public Schools Central Office lacked an effective process to ensure that the journal entries were properly reviewed and approved prior to posting to the general ledger.

These conditions occurred because written policies and procedures were not in place to ensure that all journal entries were properly prepared, supported with descriptions and documentation, and reviewed and approved by a designated person with authority prior to recording in the general ledger. As a result, (i) there was an increased likelihood of questionable and unjustified accounting entries, (ii) the financial statements may be misstated, and (iii) the failure to implement
17

Magnolia Foundation Schools Academic and Financial Policies and Procedures, page 44, as of February 2012

29

effective processes and procedures over journal entry transactions increased the potential risks of fraud, abuse and misuse of funds. We discuss the actions needed to correct these conditions in Recommendation B-4.

Competency of Staff
The Magnolia Public Schools Central Office accounting staff lacked adequate competency and training necessary for the proper accounting and reporting of the financial transactions of the Charter Schools. The United States General Accounting Office Standards for Internal Control in the Federal Government states, A positive control environment is the foundation for all other standards. It provides discipline and structure as well as the climate which influences the quality of internal control. Several key factors affect the control environment. One key factor is the managements commitment to competence. All personnel need to possess and maintain a level of competence that allows them to accomplish their assigned duties, as well as understand the importance of developing and implementing good internal control. Management needs to identify appropriate knowledge and skills needed for various jobs and provide needed training, as well as candid and constructive counseling, and performance appraisals. 18 Test Work Performed During our review of the accounting records and the activities performed by the Magnolia Public Schools Central Office staff, we noted several deficiencies in the manner the accounting staff processed and maintained the financial transactions: Accounting records were not properly recorded and maintained, such as: o Some bounced checks (No Sufficient Fund) were recorded as deposits and revenues. o Some transactions were misclassified to the incorrect account code (i.e. Dues and Membership instead of Professional/Consulting Services, Travel and Conferences instead of Rentals and Leases, Travel and Conferences instead of Employee Benefits.) o Some transactions were not recorded in the proper accounting period (i.e. FY 2010 liabilities recorded in FY 2011, FY 2011 deposits recorded in FY 2010.)

18

Standards for Internal Control in the Federal Government, issued by the United States General Accounting Office, page 8, November 1999.

30

o Some checks and EFT payments were processed based on copies of electronic mail, statement of accounts, duplicate invoice, etc. which resulted in a number of duplicate payments. o Some accounting records and reports were not completely maintained (i.e. transaction journals not printed and filed, deposits records on file were incomplete.) The Magnolia Public Schools Central Office management and staff did not strictly observe the policies and procedures for authorization and approval of transactions (i.e. journal entries, disbursements, cash receipts/deposits, bank reconciliation statements).

These conditions occurred because i) the responsibilities for the accounting of financial transactions and records were not clearly defined, ii) the Magnolia Public Schools Central Office staff lacked adequate training and proficiency in the use of the accounting system, including the proper use of the chart of accounts, and iii) there was inadequate supervision and guidance of staff. As a result, the failure to assign competent and adequately trained staff to carry out the fiscal and accounting responsibilities of the organization increased the risk of unreliable financial records. This could also result in reduced credibility of the financial statements due to errors in processing and reporting of accounting transactions. We discuss the actions needed to correct these conditions in Recommendation B-5.

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RECOMMENDATIONS AND COMMENTS

Recommendation B-1: The Board of Directors of the Magnolia Public Schools should: Direct the Chief Executive Officer, in coordination with the Chief Financial Officer to: o Ensure that cash receipts and bank deposits are reconciled, reviewed and adequately supported with appropriate documentation and source records prior to processing and recording in the general ledger. o Update and enhance the cash receipt and deposit processes to include the clear assignment of responsibilities, documentation and record retention, recording and reconciliation, and the review, authorization and approval procedures. o Provide adequate oversight over the cash receipts and bank deposits to ensure that operational procedures and internal controls provide adequate assurance that authorized transactions are processed completely and accurately in a timely manner. Charter School Comments: The management agreed with our recommendation. Following the audit, the Chief Executive Officer, in coordination with the Chief Financial Officer, implemented additional controls regarding the cash receipts and deposit processes. The Chief Executive Officer and the Chief Financial Officer are working collaboratively to ensure that all cash receipts and bank deposits are reviewed and adequately supported with appropriate documentation and source records prior to processing and recording in the general ledger. Also, the written policies and procedures will be updated to include job descriptions, documentation and record retention, recording and reconciliation, and the review, authorization and approval procedures. In addition, the Board will instruct the Chief Executive Officer to provide adequate oversight over the cash receipts and bank deposits to ensure that operational procedures and internal controls provide assurance that authorized transactions are processed completely and accurately in a timely manner. The target date of implementation is September 30, 2012.

Recommendation B-2: The Board of Directors of Magnolia Public Schools should: Instruct the Chief Executive Officer, in coordination with the Chief Financial Officer to: o Ensure that purchases/expenditures are authorized, approved and adequately supported with pertinent documents and source records prior to processing of the payment. Also, the approver should review all documentation before signing the checks to ensure that the transactions actually occurred, and are recorded in the general ledger for the correct amount, to the appropriate account code, in the proper accounting period. o Update and enhance the policies and procedures over the purchasing and disbursement processes to include the clear assignment of responsibilities,

32

appropriate documentation and record retention, proper review and reconciliation, and authorization and approval procedures. o Strengthen policies and procedures over the EFT transactions by providing adequate controls to ensure that EFT payments are limited to immediate or emergency situations only. o Provide adequate oversight and enforcement of controls over the expenditures and disbursement to ensure that operational procedures and internal controls are working effectively. Charter School Comments: The management agreed with our recommendation. Following the audit, the Chief Executive Officer, in coordination with the Chief Financial Officer, implemented additional controls regarding the expenditures and the payments processed through the electronic fund transfers (EFT). MPS management has utilized a software (CoolSIS) to ensure that all purchases/expenditures are properly authorized, approved and adequately supported with pertinent documents and source records prior to processing of the payment. In addition, the Chief Executive Officer, in coordination with the Chief Financial Officer will i) update and enhance the policies and procedures over the purchasing and disbursement processes to include the clear assignment of responsibilities, appropriate documentation and record retention, proper review and reconciliation, and authorization and approval procedures, ii) strengthen policies and procedures over the EFT transactions by providing adequate controls to ensure that EFT payments are limited to immediate or emergency situations only. In addition, the Board will provide adequate oversight and enforcement of controls over the expenditures. The target date of implementation is September 30, 2012.

Recommendation B-3: The Board of Directors of Magnolia Public Schools should: Remind the Chief Executive Officer, in coordination with the Chief Financial Officer to: o Ensure that monthly bank reconciliation statements are prepared, matched to the balances of the general ledger, and compared to the accounting records to validate that the payments and receipts are fully accounted for. o Ensure that the reconciling items in the bank reconciliation statements are identified, investigated and explained and the corrective action are taken appropriately. o Ensure that the bank reconciliation statements are reviewed for accuracy, completeness and timeliness by someone who has authority or supervisory role, and is able to authorize, provide direction to the staff, and make decisions about the items under review. The evidence of review and approval should be documented, signed or initialed, and dated by the reviewer/approver. o Provide adequate oversight and enforcement of controls over the bank reconciliation statements. 33

Charter School Comments: The management agreed with our recommendation. Following the audit, the Chief Executive Officer, in coordination with the Chief Financial Officer, has implemented controls regarding the bank reconciliation processes. In addition, the Board will provide adequate oversight and controls over the bank reconciliation statements. The Chief Executive Officer and the Chief Financial Officer will work collaboratively to: i) ensure that monthly bank reconciliation statements are reviewed, matched to the balances of the general ledger, and compared to the accounting records to validate that the payments and receipts are fully accounted for, ii) ensure that the reconciling items in the bank reconciliation statements are identified, investigated and explained and the corrective action are taken appropriately, iii) ensure that the bank reconciliation statements are reviewed for accuracy, completeness and timeliness by someone who has authority or supervisory role, and is able to authorize, provide direction to the staff, and make decisions about the items under review. The evidence of review and approval will be documented, signed or initialed, and dated by the reviewer/approver. The target date of implementation is August 31, 2012.

Recommendation B-4: The Board of Directors of Magnolia Public Schools should: Direct the Chief Executive Officer, in coordination with the Chief Financial Officer to: o Develop effective policies and procedures to ensure that all journal entries are accurately prepared, adequately supported with explanation for the entry and evidenced by proper review and approval of an authorized signatory prior to recording in the general ledger. o Ensure that the accounting staff is trained on how to effectively process the journal accounting entries. The staff should generate a report, at month-end, of all journal entries recorded in the period, for review and approval by a supervisory level employee who does not have access to recording transactions in the general ledger system. o Ensure that the general journal entry reports are printed and retained on file especially at the end of the fiscal year. o Provide adequate oversight and enforcement of controls over the use of general journal entries. Charter School Comments: The management agreed with our recommendation and stated that the Board of Directors will direct the Chief Executive Officer, in coordination with the Chief Financial Officer, to develop effective policies and procedures to ensure that all journal entries are accurately prepared, adequately supported with explanation for the entry and evidenced by proper review and approval of an authorized signatory prior to recording in the general ledger. The Board will provide adequate oversight and controls over the use of general journal entries. The Chief Executive Officer and the Chief Financial Officer will work collaboratively to: i) ensure that the accounting staff is trained on how to effectively process the 34

journal accounting entries. The staff will generate a report, at month-end, of all journal entries recorded in the period, for review and approval by a supervisory level employee who does not have access to recording transactions in the general ledger system, and ii) ensure that the general journal entry reports are retained on file especially at the end of the fiscal year. The target date of implementation is August 31, 2012.

Recommendation B-5: The Board of Directors of Magnolia Public Schools should: Direct the Chief Executive Officer, in coordination with the Chief Financial Officer to: o Assess the level of staffing and the competency of the individuals assigned to perform the accounting of the financial transactions of the schools. o Determine whether the current knowledge and skills are adequate to perform the required tasks. o Provide the accounting staff with the formal job description defining the tasks and the duties and responsibilities required of the job. o Provide continuous training and updates on the accounting system, policies and procedures, rules and regulations and generally accepted accounting principles. Charter School Comments: The management agreed with our recommendation. Following the audit, the Chief Executive Officer, in coordination with the Chief Financial Officer, has: i) assessed the level of staffing and the competency of the individuals assigned to perform the accounting of the financial transactions of the schools, ii) determined whether the current knowledge and skills of the staff are adequate to perform the required tasks, iii) provided the accounting staff with the formal job description defining the tasks and the duties and responsibilities required of the job, iv) started an ongoing onsite training and oversight as well as updating on the accounting system, policies and procedures, rules and regulations and the generally accepted accounting principles, v) asked some staff members to attend necessary workshops and seminars like Chief Business Officers seminar, QuickBooks workshops, and etc.

Questioned Costs: The summary of questioned costs (please refer to Appendix A) represent amounts identified in the review of statistically selected documentation supporting the financial activities of the three MSA Schools only. The dollar amounts represent (i) costs that were not supported by adequate documentation, (ii) costs that may have resulted to noncompliance or possible noncompliance of applicable requirements of a law, regulation, and the Charter Agreement, and (iii) the potential misuse of funds. Magnolia Public Schools Comments: We have reviewed the summary of questioned costs. The Chief Executive Officer, in coordination with the Chief Financial Officer, has met with the accounting staff to review the amounts identified in the audit. We have worked collaboratively 35

to make the necessary corrections and adjusting journal entries, and to recoup the amounts of double payment. Furthermore, we have implemented additional controls and monitoring procedures to preclude the erroneous processing and reporting of the financial transactions of the Charter Schools.

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APPENDIX A

SUMMARY OF QUESTIONED COSTS IDENTIFIED IN THIS AUDIT*

DESCRIPTION AMOUNT CATEGORY

1) Unsupported and unresolved reconciling items in the Bank Reconciliation Statements i. Outstanding/Staled Checks MSA-1 MSA-2 MSA-3 Outstanding checks dated 12 months and over remained as reconciling items even after a considerable period of time.

5,050.56 31,899.16 2,894.79

$39,844.51

2) Questionable expenditures/disbursements i. Duplicate payments to vendors MSA-1 Potential misuse of funds; the payments were improperly supported by duplicate invoices or emails.

$43,565.18

$43,565.18

TOTAL QUESTIONED COSTS

$83,409.69

* The amounts included in this appendix represent questioned costs identified in the course of the audit of the three selected Charter Schools only. The dollar amounts represent (i) outdated and unsupported reconciling items in the bank reconciliation statements, and (ii) potential misuse of funds.

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APPENDIX B

SUMMARY OF QUESTIONABLE ACCOUNTING PRACTICES IDENTIFIED IN THIS AUDIT*

DESCRIPTION AMOUNT CATEGORY
1) Unsupported and unresolved reconciling items in the Bank Reconciliation Statements i. Deposit in Transit MSA-1 MSA-2 Deposits in transit that remained outstanding from five months to almost a year as of June 30, 2011.

$22,112.79 100,246.69

$122,359.48

2) Questionable and unsupported cash receipts/bank deposits i. Double posting of deposit MSA-2 Recorded twice in the general ledger on 07/27/10. No adjusting entry has been made as of June 30, 2011.

$23,665.69

$23,665.69

ii.

Bounced checks (No Sufficient Fund) recorded as revenue MSA-1 MSA-2

13,359.90 60,090.34

$73,450.24

Bill payments returned by the bank due to NSF were credited to the revenue account. No adjusting entry has been made as of June 30, 2011.

3) Misapplication of the Generally Accepted Accounting Principles i. Deposit transactions were not recorded in the proper accounting period. MSA-1 MSA-2 MSA-3 Deposits actually received on FY 2011 were recorded as Cash in Bank on June 30, 2010. As a result, the financial records reflected positive balances in the Cash in Bank instead of zero or negative balances.

$488,968.20 115,059.82 32,643.53

$636,671.55

ii.

The Matching Principle of expenses was overlooked or ignored. MSA-1 MSA-2 MSA-3

92,517.57 81,119.01 61,989.72

$235,626.30

The goods and services incurred on FY 2010 were not accrued on June 30, 2010. The expenses were recognized on FY 2011 when the payments were made.

TOTAL

$1,091,773.26

* The amounts included in this appendix represent questionable accounting practices identified in the course of the audit of the three selected Charter Schools only. The dollar amounts represent costs that resulted from i) irregular accounting practices, and ii) misapplication of the Generally Accepted Accounting Principles.

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ANNEX A

Verbatim Comments

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ANNEX B

Report Distribution
Members, Board of Education Superintendent of Schools Sr. Deputy Superintendent of School Operations General Counsel Director, Innovation and Charter Schools Division Business Advisor, Innovation and Charter Schools Division

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ANNEX C

Audit Team
Jas Ahmed, Audit Manager Dolores Mabini, Senior Internal Auditor Emmaliza Baquir, Internal Auditor

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Know about fraud, waste or abuse?

Tell us about it.

Maybe you are a School District Employee, or maybe you are a private citizen. Either way, you are a taxpayer. Maybe you know something about fraud, or waste, or some other type of abuse in the School District. The Office of the Inspector General has a hotline for you to call. You can also write to us. Call the Hotline: If you wish, we will keep your identity confidential. You can remain anonymous, if you prefer. And you are protected by law from reprisal by your employer. (213) 241-7778 Or 1-866-LAUSD-OIG Write to us: Fraud Hotline Center 333 S. Beaudry Ave., 12th Floor Los Angeles, CA 90017 Website: www.lausdoig.org

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