A3 Charter Scandal Reveals Major Flaws in State’s Auditing Process
Grand jury transcripts drive home the extent to which the only process standing between California schools and fraud is fraught with problems that can be exploited by bad actors.
This post has been updated.
California lawmakers created a system that places just one process at the forefront of detecting fraud and mismanagement in the state’s schools: a yearly audit, conducted by a “state-approved,” “independent” auditor, according to the Department of Education.
But these auditors are not independent, in so much as they are hired and fired at will by the schools they are auditing. The term state-approved is also something of a misnomer. To qualify as an approved firm, the State Controller’s Office must only verify that the potential auditors are accountants in good standing with the California Board of Accountancy.
No special training or vetting required.
The audits themselves are also not designed to dig deeply into a school’s finances, according to transcripts from a grand jury proceeding into an alleged $80 million charter scam obtained by Voice of San Diego.
A3 Education operated 19 online charter schools around the state. The schools enrolled thousands of students, some real and some fake, prosecutors say. Two men at the top of the alleged scheme funneled $80 million out of the public education system and into companies they controlled, prosecutors say.
Even though few other people ever existed on the companies’ payrolls besides the owners, auditors following standard procedures missed that part of the alleged scam, as well as others, according to the grand jury transcripts.
“They’re not designed to catch fraud at all,” Michael Fine, who runs a state fiscal watchdog agency called the Fiscal Crisis Management and Assistance Team, told Voice of San Diego. “To have a certain confidence level in the numbers, they do some testing of transactions. But that testing is fairly limited.”
Fine said there’s another critical element that could limit the auditors’ effectiveness: They rely on what school management teams show them, rather than getting much behind the numbers.
During the grand jury proceedings in May, Jeffrey Hill, an auditor hired by A3, admitted as much.
Deputy District Attorney Leon Schorr, who handles public corruption cases, asked Hill how much an audit can be relied on to detect fraud.
The company’s “responsibility is to provide all the documents that are related to financial activity,” Hill said. “If management decides not to provide some information, and that information results in misappropriation of assets, stealing, basically, then we, as auditors, there are no procedures to uncover that.”
He added: “I’ve had experiences where, you know, clients have stolen money from the organization through an elaborate scheme that we could not uncover because the client didn’t give all the documents necessary.”
In the case of A3, payroll records might have been enough to tip off auditors that something was amiss.
Between 2016 and 2019, 12 different A3 schools (all operating under different names) paid out $25.9 million to A3 Education, according to financial records entered as evidence during the grand jury hearing. This money, in theory, was going toward back-office services and bookkeeping. But A3’s payroll records, which were also entered into evidence, show that for much of the company’s existence, only two people were being paid to work there.
Those two people were Jason Schrock and Sean McManus, who were charged as the ringleaders of the scheme.
During some pay periods, the company listed three or four employees. During one it listed five, according to the payroll records.
The A3 schools also paid out another $57.3 million to three other companies also controlled by McManus and Schrock, according to the records. A3 Education was established as a nonprofit company, but at least one other company controlled by McManus and Schrock operated as a for-profit, according to business filings.
Auditors saw all these large payments from the A3 schools to the various other businesses, but for the most part did not consider them suspicious.
California law prohibits public officials from striking deals with companies in which they have a financial interest.
A previous auditor had flagged concerns about self-dealing among the A3 schools and related companies in December 2017. The auditor noticed that McManus was listed as the head of one of the A3 schools, but also managing companies with which the school was doing business.
After that audit was complete, Schrock and McManus terminated their relationship with the previous auditor and engaged the services of Hill, who testified before the grand jury.
Hill did follow up on the previous concern about related-party transactions. But by that time, Schrock and McManus had changed the paperwork to show that someone else was running the school, according to an indictment filed by prosecutors.
Because the paperwork checked out, Hill considered the case closed, he told prosecutors.
Hill did not return calls to a phone number listed for his accounting firm.
Auditors of online and independent study schools like those controlled by A3 are also required to look into two other areas that aren’t typical in a traditional audit.
Because online schools are not based in a classroom, attendance is calculated by a teacher who considers the amount of work a student completed over a given period of time. In A3’s case hundreds of students were allegedly enrolled in classes who completed no coursework at all.
Many were participating in summer athletic programs, like football, and enrolled in A3 schools only for the summer. Their academic program appeared to only consist of them attending football practice, according to the indictment. Football teams as well as enrollment workers received a commission from A3 for each player enrolled. Schrock and McManus watched the money stack up.
But neither Hill, nor the previous auditor Squar Milner, sensed the schools might be enrolling fake students. Because the paperwork looked right, Hill believed the students were real, he testified.
Auditors are also tasked with verifying that online schools spend 80 percent of their budget on “educational services,” which must also include 40 percent going toward teacher salaries. (Online schools must meet this requirement if they are to receive 100 percent funding from the state, like a brick-and-mortar school.) Because the A3 operators showed paperwork suggesting they met the requirement, even though it seems clear they did not, auditors excepted it.
Yearly audits are also designed to catch problems at traditional public school districts. Officials at Sweetwater Union High School District manipulated budget entries to make it look like the school district wasn’t overspending, according to previous comments by Fine, the head of the fiscal crisis agency, and reporting by Voice of San Diego.
Despite previous audits, district officials’ actions did not come to light until Sweetwater suddenly came up $30 million short in September 2018.
The superintendent of Montebello Unified School District in Los Angeles County was recently fined by the Securities and Exchange Commission for financial misdealings. That district previously fired auditors before they could complete a damaging report, Fine said.
Fine acknowledged that the state’s approval process for verifying auditors is not much of an approval process at all. He also called into question auditors’ independence.
“There’s not a whole lot that’s independent about them,” he said. Charter schools and school districts “pick their own auditor and enter into a contract with them agreeing to pay them and write the check. They can terminate them at anytime. How independent is that?”
When asked whether the current auditing standards are sufficient enough for uncovering fraud, a state Department of Education spokesman said the primary responsibility for “overseeing a program to review and report on financial and compliance audits” rests with the State Controller’s Office.
Once completed, school audits are submitted to the Department of Education, not the Controller’s Office. Jonathan Mendick, the spokesman, also noted that general accounting standards require “auditors to assess and report fraud that is material to the audit objectives.”
As Fine, in an interview, and Hill, in his testimony, make clear: the “audit objectives” are fairly limited compared to the type of audit that would be designed to detect fraud. Mendick also noted a temporary, two-year moratorium on non-classroom based charters like A3 that was recently signed into law.
One way to inject more independence into the process, suggested Fine, would be to have the State Controller’s Office enter into contracts with auditors on behalf of school districts. That would at least put the ability to hire and fire in someone else’s hands, he said.
He also suggested that districts or schools come up with a committee, partially made up of community members, to help manage audits.
“You build a system so the auditor doesn’t report to one party, but to multiple parties,” he said.
He also said he would not recommend the state itself take over audits. “I would worry about anything you give to the state on that scale,” he said. “It has great potential to get messed up.”
During the grand jury proceedings, Hill tried to assure jurors and prosecutors that an auditor would hopefully catch any indication of fraud.
“If we see something that is an indication that the organization is not spending the money properly … then that hopefully would be uncovered through our audit procedures,” he said. “But again, it’s – it’s an art, not a science. So there’s no guarantee.”
Update: This post has been updated to include information from the state Department of Education.