FROM outside it looks like a double dip has hit the United States stock markets as predicted. Investment boards on Wall Street have turned red and massive losses remind one of the 2008 global financial crisis.

Unlike 2008, when China's resilience helped the US and the world to cushion some of the global financial pain, Chinese companies listed in the US are now standing alone to face the onslaught of bearish investors.

The root cause for the crash has not been runaway inflation or a breakdown in China's economic fundamentals. Neither has it been China's long anticipated property market crash - but fraud. Or more accurately: stock investors' sensitivity to perceptions of fraud.

The fraud bomb came in two ways. Slowly and then fast.

The slow cause has been the simmering concern about reverse mergers.

Bloomberg reported that since 2007 more than 150 Chinese companies had entered US stock markets through reverse mergers, also known as backdoor IPO listings.

The potential problem with these mergers is that it allows companies to turn public - by merging with US-listed shell companies - without undergoing strict screening and financial scrutiny usually required prior to main board IPOs.

The fast cause was a series of five slamming research reports exposing alleged accounting irregularities among US-listed Chinese companies.

The latest of these reports published by a boutique investment company, Muddy Waters, came out in the first week of June and accused Sino-Forest Corp, a Hong Kong- and Ontario-based timber farm operator, of overstating its land holdings and production figures.

The company's Toronto-listed stock subsequently tanked 89 percent, sparking the biggest monthly decline for Chinese companies listed in Canada in three years. An index of these companies shrank 13 percent over the first two weeks of June, echoing a 24.7 percent fall Chinese stocks experienced during April in the US.

All the implicated companies have denied Muddy Waters' accusations. The US Securities and Exchange Commission is currently also investigating alleged irregular trades by Muddy Waters in Sino-Forest stock.

But the damage has been done because the fraud bomb is bigger than just Muddy Waters. Forbes reported that close to a third of securities fraud cases opened over the past two months are related to Chinese microcaps - "some" of them entered the US via backdoor IPOs.

"There has been a huge explosion of cases in the last quarter," Andrei Rado, a plaintiff lawyer at Milbrerg LLC told Forbes. "The fraud that Enron and WorldCom committed in the 90s and early 2000s was more sophisticated. These guys are much bolder in what they do," says Rado. "Some of these companies are a complete sham."

The timing couldn't have been worse for Chinese companies. Europe is spooked again by a potential Greek default, the US is getting used to the end of quantitative easing and China has slammed monetary breaks on its economy and expects GDP growth to slow.

Also, the fraud expose comes as top US and other foreign investors have shown bullish interest in Chinese-run companies, helping to boost Chinese stock's profile as a good buy.

Loophole

So how could a scandal like this have been avoided? By being honest and prudent?

It is clear that, through backdoor listings, Chinese speculators have found a loophole into the world's biggest, most liquid equity market and if there is money to be made through this backdoor, then it will be exploited. So one starting point could be for the Securities and Exchange Commission to start closing the loophole or legislate it more strictly.

But the real issue is the one exposed by Muddy Waters' research -inconsistency in Chinese companies' accounting procedures at best, or fraud at worst. By actively following the set international accounting standards and corporate governance rules already in place around the world, this crisis would never have happened - in theory.

Although China's Basic Accounting Standards for Business Enterprises incorporate key principles of the International Financial Reporting Standards, there are concerns that the Chinese standards do not completely replicate the IFRS as intended by the international accounting standard setters, a CFA Institute report stated in 2007.

Corporate governance has been adopted as a "top priority" by China's central government in the its drive to develop the country's financial markets. The CFA report found that although multinational Chinese companies are aware how good corporate governance could help make them more attractive to international investors, China started its corporate governance reform in an environment where most of the elements of a well-functioning financial market were not in place.

The elements include a well-defined legal system, efficient regulatory agencies, and rigorous law enforcement.

Four years after the CFA report, studies still find that good governance "is still at its nascent stage" at China's biggest listed companies.

A recent article by investment researcher Motley Fool Global Gains, which is presently touring China in search of good companies to invest in, beautifully illustrates the alchemical accounting magic being practiced by Chinese listed companies through keeping multiple sets of accounts.

These different accounts report different, generally higher, numbers to US investors in their SEC filings than to Chinese regulators.

"One reason, explained the founder and CEO of a private pharmaceutical company in Beijing, is that the corporate tax burden in China is so punishing - with payments often deducted from revenue rather than income - that it can be difficult to make a go of it if you don't underreport your results to the government," the company wrote.

Then there is the moral hazard: "If everyone else is cheating and getting away with it, the company that instead opts to pay its corporate taxes will be at a massive competitive disadvantage," it added.

It's clear that Chinese rules for adequate and timely disclosures are in place. There is a watchdog. Although it appears that the Chinese rules mimic international standards but do not retain the essence.

There are few incentives to implement good governance within the country and the cost for complying is high. Therefore, it makes financial sense not to stick to the rules within China.

This is no secret. The National Audit Office of China recently found 17 state-owned countries had blown up their earnings.

Muddy Waters, through its China expert founder Carson Block, is exploiting this inconsistency and probably reaping short selling profits through his hedge fund.

Judgment day has arrived.

Chinese companies, being part of a global economy, have no excuse not to produce reliable and transparent accounting figures that could be used by investors with no grain of doubt. That is not negotiable.

Without the confidence and authority gained through clean, transparent and accurate accounting, the country will never see its financial markets develop or gain the recognition and respect it aspires to get from the rest of the world.

Not all Chinese companies are fraudulent, one can be sure, not all cook their books, but through the actions of a few it is now the general perception to the rest of the world that all Chinese companies are murky. Even search engine Baidu, which has not been implicated in the exposes, has lost a quarter of its value.

Investors confidence

How can China win back investor confidence? Financial policing needs to be stricter. A recent positive signal was when China's state-owned enterprises supervisor in May said it would conduct transparency audits in a bid to increase transparency in state-owned enterprises' management, www.gov.cn reported.

At the same time, efforts must be made to establish a culture that rewards transparency and good governance. Policing should be supported by tax incentives for companies to report accurately, like attractive write-offs for capital items used to generate profits. And taxing companies' net profits, instead of revenue.

Finally, there may be some good news hidden behind the stock price massacre. Value investors will have a chance to sift through the rubble, identify which companies' business models are dodgy and which are sound.

Waiting for them to bottom out again, these sound companies will become long-term buys again - if the scandal fades away. There are already signs that investors are doing just that.

One's pain is potentially another's gain in the violent world of equity markets.