Dame Jean Else, 53, who is currently suspended, paid a personal friend £13,200 as an unauthorised consultant at Whalley Range High School for Girls.
Her twin sister was also employed as a clerical assistant before rising to become assistant headteacher.
The Audit Commission said legal action would not be in the public interest.
Dame Jean had been hailed by the government as an example of its approach to education after transforming the performance of the inner city school when she was appointed in 1994.
She saw her salary rise from £76,193 to £141,653 between 1999 and 2003.
But she was investigated by the Audit Commission after a whistleblower at the school made allegations of nepotism in October 2002.
The report said her appointment of her twin sister, Maureen Rochford, had been a "clear conflict of interest".
Ms Rochford, who was suspended along with her sister and another member of staff, Stewart Scott, in November, had been appointed in 1995.
The commission said there had been "defects" in the paperwork of Ms Rochford's job application and Dame Jean had been guilty of a "serious and continuing lapse of judgement".
The value for money in appointing her sister and the amount of money paid to her and Stewart Scott was "questionable" while management costs were "disproportionately high" compared to other schools, the commission added.
The report also revealed £13,200 had been paid to a personal friend for consultancy work, but £9,000 of that sum had been paid without the knowledge of the school governors.
Dame Jean had believed that tendering for the work was "not required", the report said.
She also said she did not accept criticism over the employment and pay of her sister.
"The considerable success of the school, which had previously underperformed significantly, was due to our policy of employing the best people in each post, whoever they happened to be," she said.
"I remain a professional head teacher committed to the highest standards in everything our school does."
The local education authority was also criticised for not supervising and supporting the school governors properly.
Manchester City Council said no-one from the local education authority had been disciplined and refused to comment further.
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