The Philadelphia School District owes the U.S. Department of Education $7.2 million for federal grant funds misspent more than a decade ago, a federal appeals court ruled last week.

The decision comes as the district struggles in the face of the state's continuing budget impasse. Unless the district receives its full allotment of state money, officials say, schools will not be able to remain open through June.

Raven Hill, a district spokeswoman, said Friday: "At this time, the School District is reviewing the opinion internally and with outside counsel."

The case stems from a federal audit in 2010 that found "widespread misuse" of $138.4 million in grant funds from July 1, 2005, through June 30, 2006.

In its audit, the Inspector General's Office of the U.S. Department of Education said money intended to educate low-income students was spent on things such as catering, a mini-fridge, a microwave oven, greeting cards, and salaries and benefits for employees who had nothing to do with the grants.

But a former chief financial officer told authorities federal grant money had been used to help plug a $66 million deficit.

Government reports said that the district's budget and grant monitoring practices in 2005-06 "suffered from systematic failures," and that the record was "replete with actions by [the district] that were intentional, improper, and taken with reckless disregard for the regulations and statutes."

The district has since tightened its fiscal management.

The government at first sought the return of $10 million. The amount was reduced to $7.2 million based on a five-year statute of limitations.

The case moved through hearings at the Education Department for years as the district and the Pennsylvania Department of Education together challenged the audit findings.

It landed at the U.S. Court of Appeals for the Third Circuit last December. The state education department asked the court to overturn a decision by former U.S. Education Secretary Arne Duncan, who had ordered $7.2 million repaid.

In an opinion filed Thursday, a three-judge panel declined to review the matter, allowing Duncan's order to stand.

Casey Smith, deputy communications director at the Education Department in Harrisburg, said the state was involved because the department administered the federal grants Philadelphia schools had received.

Smith said the department could ask for the entire Third Circuit Court to re-examine the case or appeal to the U.S. Supreme Court. "The department has not yet decided its next steps," he said.

In the fiscal year that ended June 30, 2006, the district received $245 million in federal grants. In May 2007, the Office of Inspector General began a comprehensive audit to see how the money had been used.

A spokeswoman said the office was auditing large districts at that time, and Philadelphia was one of them.

The final report found that the district lacked written fiscal policies and procedures for grants, had not followed its contracting policies, and had used federal grant money to buy items and pay for services that were supposed to be paid with local and state funds.

Auditors said district staffers told them in interviews that officials had known since the fall of 2005 that the district was heading toward a deficit.

The reports said a former chief financial officer told auditors that the deficit was partly the result of a lack of internal financial controls. That official also said district higher-ups began using federal grant money to pay other bills to reduce what had become a $66.1 million deficit.

The strategy - which violated federal guidelines - was described in spreadsheets for the former CEO as "deficit relief," the auditors said.

Folasade Olanipekun-Lewis, the district's chief financial officer at that time, said Friday that she did not speak to the auditors on the matter because she had left the district before the inquiry began. She said auditors would have talked to one of her successors.

Paul Vallas, the district's CEO at that time, was not named in the report. He could not be reached for comment Friday. But shortly after the 2010 audit was released, he had disputed its findings.

"Nowhere in the report does it suggest officials engaged in the misappropriation of federal funds during the audit period," Vallas said in January 2010.

He also said that the federal government had been encouraging schools "to use grant money in more flexible ways."

Using federal grants to plug a deficit was not mentioned then.

Vallas left the district in June 2007 amid rancor over a "surprise" deficit of $73 million that emerged in the fall of 2006.

martha.woodall@phillynews.com215-854-2789@marwooda