The conversion settings are probably set to 2-channel, which is why multichannel flacs don't work. I don't know if MC handles converting ISO files on-the-fly well, so that may not be possible. However...
On my client, I have ticked Always Convert Audio to PCM 24-bit. My Audiophile ears tell me this sounds better than not converting.
This makes no sense, and is counter-intuitive.
With this option OFF:
* The MC Server sends the audio files to the client
UNALTERED via HTTP.
* The Client decodes them (using the exact same audio engine that the server uses) and sends them to the output device as PCM appropriately.
With this option ON:
* The MC Server decodes the audio files and re-encodes them as PCM (again, using the same audio engine as the client).
* Then it sends these PCM files (much larger than the originals, using FLAC as an example) to the client via HTTP.
* Then the MC Client just handles playing the PCM back.
So, with it on and set to PCM, what you've accomplished is you've moved the necessary PCM decoding step from the client to the server. Since both the client and the server have identical audio engines, this has only accomplished loading your network with additional data (sending larger pre-decoded PCM files, rather than smaller FLAC files), and you've limited (or made fiddly) your playback capabilities.
The main point of this option is to force the server to encode music to
smaller formats (like MP3) to ease streaming in bandwidth-limited environments (like streaming over the Internet, for example). If you are at home on your LAN, then it makes no sense to pre-convert for another copy of MC. For DLNA it might be entirely different because the decoding system may be incapable of some formats that MC can decode. But when using MC talking to another copy of MC, then it makes little sense to pre-convert to PCM.
I think your "audiophile ears" are deceiving you because of (a) the placebo effect and (b) an incorrect assumption about what the option does.