Poor budget management at Hackney, east London, meant the council did not realise the size of its deficit until halfway through the following financial year.
Council staff are heavily criticised for their financial management in an interim report by an improvement team appointed by the Government which was released today.
School standards minister Stephen Byers said the Government fully backed the team's report and recommendations.
"I am encouraged to note that progress is being made. However, no one should be in any doubt that there is still much more that needs to be done to fully support the children of Hackney."
The hit squad was appointed by the Government last year after school inspectors condemned Hackney's education service as being "in disarray".
Its first recommendation - the appointment of a chief education officer - has just been implemented by Hackney and it will be working with appointee Elizabeth Reid to produce its final report in June.
Oversights singled out in the report include the authority discovering in December last year that schools had not been charged for gas supplies for up to three years - which could result in a bill of close to pounds 1m for headteachers.
And the team also highlighted a shortfall of pounds 966,000 between the budget allocation for staff in 1997-98 and the actual staff costs for posts that were already established and filled.
Where money has been saved, the report goes on, it was "not from decisive management, but from keeping posts vacant as staff have left".
The team says proposals to further devolve financial planning could make matters worse.
"Though the reorganisation is planned to ensure value for money of public funds, we have considerable doubts whether this will be the final outcome."
Instead it suggests the council commissions a comprehensive financial review.
David Hart, general secretary of the National Association of Head Teachers, said: "This report confirms the worst fears of head teachers in Hackney.
"The financial systems are clearly a disaster and the incompetent management of its finances has placed school budgets at risk."Reuse content