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Predicting Material Accounting Misstatements*

Another argument why public capital markets can create incentives to reduce the informativeness of earnings in specific situations is based on earnings targets. Beatty et al. (2002) argue that small investors in stock markets are more likely to rely on simple heuristics such as earnings targets than fairly sophisticated private investors (e.g., banks), which makes public firms more likely to engage in earnings management to exceed targets. Similarly, public firms may manage earnings to meet or beat capital market expectations as expressed in analyst forecasts. Stock based compensation contracts can further exacerbate these incentives (e.g., Guttman et al., 2003). Consistent with these arguments, Beatty and Harris (1999) and.