South Korea's government has been advised to punish military leaders over alleged failings connected to the sinking of the Cheonan.
State auditors said 25 people should face disciplinary action for hiding or distorting details of the attack on the ship.
The Cheonan sank on 26 March, killing 46 sailors. International investigators say a North Korean torpedo sank it.
Seoul has formally referred the issue to the UN Security Council for debate.
South Korea's Board of Audit and Inspection (BAI) said there had been several key errors by the military, including the failure to take precautionary steps following reports of North Korean submarine activity in the days before the attack.
Then once the attack had happened, there was a delay in informing some top officials, while military figures "hid or distorted some facts in its initial reports".
The chairman of the Joint Chiefs of Staff, two civilian ministry officials and 22 other senior officers are criticised in the report.
An unnamed defence agency official told Yonhap news agency that the Cheonan attack had "revealed a huge hole in terms of national security".
"A large-scale punitive shake-up is unavoidable to restore people's trust in the military," the unnamed official said.
News of the potential shake-up comes a day after it emerged that North Korea had sent a letter to the president of the UN Security Council, denying any responsibility for the attack and urging the council to help Pyongyang conduct its own investigation into the incident.
South Korea has rejected the North's request to send its own investigators.
The warship row has left inter-Korean relations highly tense. Seoul has suspended inter-Korean trade and Pyongyang responded by cutting all ties.