Didn't some of these first come out on cassette tape? Which has horrible quality *hissssssss*
They probably just don't want their product floating around as MP3s... So in saying it doesn't work that way cuts down a bit on pirating I imagine.
Apple stinks in that way, I have an iShuffle. You can make it so your iShuffle will work like a typical MP3 player...
iPod Shuffle without iTunes - Hack A Day
I've tested different formats and it doesn't seem to matter... WAV, FLAC, AAC, MP3