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May 17 (Bloomberg) -- Stockton, the California city trying to stave off bankruptcy, didn’t reconcile its main checking account each month and left millions of dollars in library fees uncollected, fueling a fiscal crisis as managers left.

The fiscal 2010 accounting blunders, outlined in a February 2011 report to the City Council, offer a glimpse into how municipal leaders lost financial control, prompting a state investigation. The report was prepared by an outside auditor.

“In order to run a city, business or anything, you have to understand your financial position,” said Linda Biek, director of governmental, international and professional relationships at the National Association of State Boards of Accountancy.

The community of about 292,000 residents 80 miles (130 kilometers) east of San Francisco is talking with creditors to avoid becoming the largest U.S. city to enter bankruptcy after mounting retiree health-care costs, the recession and accounting errors left it almost insolvent. The state said last month it would investigate Stockton’s financial practices and reporting.

“If the organization lacks internal control, there is more opportunity for things to go wrong,” Biek said by telephone from Nashville, Tennessee. “It’s possible that lack of internal control could allow for corruption or fraud. It’s also possible the money could be going through the wrong accounts.”

Municipal Company

If the city decides to abandon talks and seek court protection, it would join Central Falls, Rhode Island, which entered Chapter 9 bankruptcy in August after failing to win union concessions, and Jefferson County, Alabama, which became the biggest municipal bankruptcy in U.S. history in November, with $4.2 billion in debt. Vallejo, California, entered Chapter 9 in 2008, emerging from the process last year.

In a May 15 council meeting, City Manager Bob Deis presented three options for closing a $26 million budget gap. He listed court protection, making massive departmental cuts or obtaining concessions through negotiations with creditors.

Stockton’s council agreed to begin talks with creditors in a Feb. 28 meeting, when it also decided to default on $2 million in bond payments and to bring in an independent investigator to probe the mishandling of its finances.

At that meeting, Deis said departments failed to chase down payments owed on municipal bills.

At the same time, “there’s just been huge turnover and people walk out the door and there’s no follow-up, there’s no transition,” Deis said. “We’ve never seen anything like this.”

Turnover of Officials

Mark Moses, a former chief financial officer, retired in July 2010 after six years. Kathleen VonAchen, a finance officer who had reported to Moses, left in March 2011 after three years. Susan Mayer, who became the city’s chief financial officer in January 2011 after helping shepherd Vallejo through its bankruptcy, left in February, a week before Deis announced he wanted Stockton to pursue talks with creditors under a new state law aimed at discouraging municipal bankruptcy.

Deis in August announced that he planned to retire, one year after he took the post. He later decided to stay on the job. His predecessor, J. Gordon Palmer Jr., retired in 2009.

A fiscal 2010 report prepared by Macias Gini & O’Connell LLP, a Sacramento-based accounting firm that had served as the city’s outside auditor for the decade that ended that year, detailed weaknesses in the city’s bookkeeping.

Uncollected Fees

The city left about $3.4 million in library fees uncollected, according to the audit.

“The reconciliation of the city’s main checking account was not being performed monthly on a timely basis, resulting in unexplained and unidentified differences,” according to the report. As of June 30, 2010, about $533,000 fell into that category, the auditors said.

“It’s a standard internal control to reconcile your bank accounts to make sure that they agree with your financial statements,” Mike Taylor, the city auditor, said by telephone. His job doesn’t include preparing financial audits.

The report also determined that the city had received a loan in 2002 that was counted as revenue instead of as a long-term liability. The report labeled the discrepancy as a sign of “material weakness,” or a deficiency in internal controls that raised the chance that financial misstatements could occur.

“The fact that there are material weaknesses and significant deficiencies, that would be a bit disconcerting to me, if I were a taxpayer,” said Biek, of the accountancy group. If the financial statements aren’t right, “then the decisions that are made may not be in the best interest of the citizens.”

Deep Problems

In a February memo to the council, Deis said that he didn’t think “it was clear just how problematic these areas were to the underlying financial condition of the city.”

“Ordinary and customary reconciliations between supporting third-party or subsidiary databases and the city’s financial books have simply not been performed by staff for many years,” Deis wrote. “Systems are out of balance and some balances reported in the city’s financial statements are unsupportable.”

He also suggested the errors may have been intentional.

“There may have existed in certain past fiscal years non-standard financial practices engaged in, either intentionally or negligently, by city administrators and/or contractors that were not disclosed to the council and that have also contributed to the city’s current financial situation,” Deis said in the memo.

In a May 2011 audit committee meeting on the fiscal 2010 report, then-CFO Mayer said the city workforce was inadequate.

Targeting Risk

“I can’t tell you that we have sufficient staff to provide the best control to meet our fiduciary responsibilities,” Mayer said, according to a recording of the session. “We’re going to try to prioritize the areas of highest risk and best leverage the resources that we do have.”

State Controller John Chiang in April sent a letter to Deis saying he planned to investigate the city’s financial practices.

Stockton’s ability to provide reliable and accurate financial data in required reports “is questionable,” Chiang wrote. He said the city hadn’t submitted a financial-transaction report for fiscal 2011 that was due in October.

“We’re in Stockton right now,” Chiang said yesterday in an interview with Mark Crumpton on Bloomberg Television’s “Bottom Line” show. “It’s early in the audit, so I have no findings to disclose.”

It’s the fourth municipal audit the controller has started, adding Stockton to reviews of Bell, Hercules and Montebello, Jacob Roper, a Chiang spokesman, said May 10 by e-mail.

Ensure ‘Sound Finances’

“We just want to make sure that we have sound finances in Stockton and every other municipality,” Chiang said. “We’re going to have to make sure that we have better disclosure.”

Chiang is backing state legislation to expand his investigative powers involving fiscally distressed local governments. He also supports a bill that would let his office set accounting guidelines and standards for city governments.

Macias, the accounting firm that audited Stockton, came under scrutiny in San Diego last year.

“It is concerning that Macias Gini & O’Connell LLP, the firm which is contracted to conduct the outside audit of the city’s annual financial statements, was recently reported to have missed two major misuses of taxpayer dollars in the last six years,” San Diego Councilman Carl DeMaio said in a July 2011 memo to council President Pro Tem Kevin Faulconer.

The firm “failed to find accounting discrepancies going back to 2005” in their audits of San Diego Medical Services, DeMaio said in the note. Macias also failed to uncover $872,000 in “unauthorized bonuses” that the Southeastern Economic Development Corp.’s former president gave herself and 15 employees from 2003 to 2008, he said.

Audit Limits

“There is some risk that you can perform an audit totally in accordance with generally accepted auditing standards, and that there is a risk that a material exception, material error could exist and not be disclosed during that audit,” James Godsey, a Macias partner, told the San Diego council’s audit committee in a September meeting about the firm’s work.

What an audit should reasonably be expected to catch “can be a difficult question to answer,” San Diego’s independent budget analyst said in a September report. Macias “has performed well for the city to date,” the official said.

Stockton’s outside auditor missed mistakes that should have been caught, Deis said at a February council meeting.

“They’re material enough to our situation that I would have hoped they would have popped up and the red lights would have come on,” Deis said.

Stockton officials have been focusing on the mediation, the controller’s probe as well as an annual audit and financial report, in addition to developing the fiscal 2013 budget, Connie Cochran, a city spokeswoman said by e-mail. She was responding to a question on whether an independent investigation was under way on the causes of its distress.

“We are focused on addressing our fiscal crisis and moving forward,” Cochran said. “Given our competing priorities, the investigation issue will be addressed in due course.”

To contact the reporter on this story: Alison Vekshin in San Francisco at

To contact the editor responsible for this story: Stephen Merelman in New York at

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