It's perfectly possible for a disk to be bootable like this, with the contents of the system folder just poured into the root level of the disk. Technically the root directory is the system folder then. I'm not sure if Apple would have ever made a disk like that but I guess it's possible.

It sounds to me like the disk has been altered from its original state. I think a possible answer would be to find an image of the first disk for system 7.1 and write over your disk with it.