When evidence of multiple incidents of fraud is discovered and there are insufficient controls in place, the internal auditor's most appropriate next step is to discuss the situation with the engagement supervisor to determine whether fraud investigation experts are needed. This step ensures that specialized expertise is considered and engaged if necessary to properly investigate the matter and to determine the appropriate response, including the potential involvement of law enforcement.References: International Standards for the Professional Practice of Internal Auditing on responding to findings and incidents of fraud; guidance on fraud investigation.

One of the possible reasons for the failure to identify transactions between the parent organization and a subsidiary is that the auditor did not have sufficient knowledge of the group structure, the consolidation process, and the related party disclosure requirements2. The auditor should obtain an understanding of the entity and its environment, including its internal control, as part of the risk assessment procedures3. This would help the auditor to identify and assess the risks of material misstatement due to related party transactions, and design and perform appropriate audit procedures to address those risks4.
References:
1: IAS 24 - Related Party Disclosures5, p. 1 2: Group audit issues | P7 Advanced Audit and Assurance | ACCA ...2, p. 1 3: INTERNATIONAL STANDARD ON AUDITING 315 (REVISED) IDENTIFYING AND ... - IFAC1, p. 1 4: ISA 550 Related Parties - IAASB, p. 1

Intentionally leaving out material observations from the audit report clearly indicates a compromise in the independence of the internal audit. Independence is fundamental to the credibility of the audit function, and any actions that suggest altering audit reports to omit significant findings undermine this principle. Such behavior may suggest an effort to avoid conflict or negative reactions from management, directly impacting the objectivity and integrity of the audit results.References: Institute of Internal Auditors (IIA) - International Professional Practices Framework (IPPF)