Advanced Audio Coding, or AAC, is a MPEG (Motion Pictures Experts Group) audio standard first adopted as part of the MPEG-2 family of standards. Like its predecessor, MP3, AAC is a Lossy Compression format capable of delivering relatively high quality at relatively low bitrates. There are actually two AAC specifications. In addition to the MPEG-2 version of AAC, which was also referred to early on as NBC for Non Backwards Compatible, there's a newer specification developed for MPEG-4. This version is normally found in the MP4 Container, either with or without accompanying video.
Audio Only Files
Although AAC is often used to accompany MPEG-4 video in the MP4 container, it's also used as an alternative to MP3 for compressed music files. The best known example of this is Apple's iTunes online store and software. iTunes AAC files are stored in the standard MP4 container, but generally with an extention of .M4A to denote that they only contain audio. AAC audio may also be used to Encode music for 3GP mobile phones, which support it in their 3GP container. This is a simplified version of the MP4 container that's optimized for use on phones.
Audio With Video
As the standard MPEG-4 container (.MP4) has been adopted by more software, including Nero (Nero Digital) and Apple (iTunes), encoding audio using AAC is quickly becoming common. It's also frequently used with 3GP mobile phones and a variety of portable media players.
AAC Object Types
Each AAC stream is called an object, and there are severaly types of AAC Objects. However, only two are used extensively in consumer formats - AAC LC (for Low Complexity) is the original AAC format developed for MPEG-2. It's good for 2 Channel audio, such as music. For multichannel surround sound, similar to theatrical formats like AC-3, you must encode to a more advanced type of AAC Object called either HE-AAC (for High Efficiency) or aacPlus. Compared to AC-3 (Dolby Digital) audio, which is typically encoded at a Bitrate of 448kbps for 5 channel surround, HE-AAC is typically encoded at a bitrate of around 240kbps for the same surround configuration.
There are a number of high quality AAC encoders available for free, including the Apple encoder included in iTunes and the Nero encoder available from their website. The Nero encoder also requires that you use some sort of front end software to provide the GUI (graphic interface).