What steps will reproduce the problem?
1. Under preferences, select encoding tab
2. for .mp3 files select -1 as bit rate limit so that they are not re-encoded
3. Select AAC Encoder from 'Re-encode copied files with:'

What is the expected output? What do you see instead?

Expected output is mp3 files in itunes to be copied without transcoding to aac. 
Apple Lossless 
files to be converted to aac files on copy.
What version of the product are you using? On what operating system?

0.95 of Itunesmywalkman
OS X 10.5.4

Please provide any additional information below.