*3.1. Theoretical Literature Review*

Two sets of approaches in literature have been distinguished by the researchers to mitigate the agency problem. The first approach is the refraining approach, which proposes that the manager's interest could be aligned with that of the shareholders only if they are forced to refrain from opportunistic behavior. The refraining approach consists of leverage (Emanuel et al. 2003; Malmquist 1990; Siregar and Utama 2008), dividend payment (Easterbrook 1984; Lang and Litzenberger 1989), the risk of corporate takeover (Bethel and Liebeskind 1993; Shleifer and Vishny 1991), a strong board structure (Bathala et al. 2017; Jackling and Johl 2009; Miller 2002), independent audit committees (Collier and Gregory 1999; Islam 2010), well-reputed external auditors (Eshleman and Guo 2014; Hope et al. 2012), and oversight by institutional shareholders (Singh and Davidson 2003).

The second approach is known as the encouraging approach, and motivates the managers to do desirable actions. This approach includes performance-based remuneration (Abowd 1990) and employee stock ownership programs (Fox and Marcus 1992; Nikoskelainen and Wright 2007; Singh and Davidson 2003). Agrawal and Knoeber (1996) suggested a different agency-mitigating mechanism and concluded that a single measure could be misleading. Shan (2015) prepared a corporate governance index for eight different corporate governance measures and explored their effect on earnings management and value relevance. Our study also focusses on the design of the corporate governance index, consisting of agency-mitigating variables, and investigates the impact of corporate

governance in moderating the relationship between agency cost and firm performance. The result shows that an effective monitoring mechanism (corporate governance quality) can align the interests of shareholders and managers.

Studies on ownership concentration and firm performance follow two contradicting theories. The monitoring argument implies that in the presence of weak governance mechanism, the majority shareholders helps in reducing the agency cost and increasing the overall firm value (Porta et al. 1999; Shleifer and Vishny 1986; Bhagat et al. 2017; Su et al. 2008; Li et al. 2008). The principal–principal theory states that the minority shareholders are exploited when the control of the ownership lies with the majority shareholders. They are the key decision-makers and appoint the management based on personal preferences. The management works to maximize value for the majority shareholders, while the minority shareholders are continuously overlooked (Denis and McConnell 2003; Hu and Izumida 2009). China is regarded as an emerging economy with corporate governance procedures still at an evolving stage. Shareholders are subject to managerial expropriations, and hence concentrated ownership may help mitigate the agency problem.

#### *3.2. Empirical Literature Review and Hypothesis Development*

#### 3.2.1. Agency Cost and Firm Performance

Emerging markets are prone to managerial discretion to a greater extent compared to Anglo-American countries. The managers in these economies tend to manage the funds inefficiently that directly effects the firm performance. Compared to developed economies, the extent of agency cost is different in emerging economies, specifically in China. Many researchers have used a proxy of agency cost based either on managerial discretion or effective use of shareholder funds. The proxies for agency cost mostly used in China are discretionary accruals as a mean to earnings management (Wang et al. 2015; Wang and Campbell 2012; Guo and Ma 2015), free cash flow coupled with low growth opportunities (Chung et al. 2005b; Chen et al. 2016; Chiou et al. 2010), research and development expenditure (Shust 2015; Dinh et al. 2016; Ruiqi et al. 2017), and administrative expense ratio, which usually includes executives' salaries, travelling allowances, conference levies, etc. (Li et al. 2008; Huang et al. 2011; Zhang et al. 2016).

Most of the literature cited on the relationship between the agency cost and firm performance has established a negative relationship. For example, management earnings lead to the negative market performance of firms listed in Hong Kong (Ching et al. 2006). Higher levels of leverage in terms of short-term debt and long-term debt also have a negative effect on firm performance (Yazdanfar and Öhman 2015). A study conducted by Lang et al. (1995) showed that managers' discretion in selling assets led to lower firm performance. Khidmat and Rehman (2014) empirically tested the relationship between agency cost and firm performance in the emerging economy of Pakistan. They found a negative association between the selling and administrative expense ratio and firm performance. The Chinese market is prone to agency cost, and we expect a negative effect of agency cost on Chinese listed firm performance.
