I've got the latest version of iTunes......10.7..... And this software ONLY converts music to AAC format.
That's not correct.
iTunes will convert to the format you have selected in the Import Settings. So if you wish to convert to a different format, select Edit/Preferences/General>Import Settings and choose the format you want. Only then wil you see Advanced/Create XXX version where XXX is the format you want.
However - that's not actually what your problem is, is it?
To make 'custom' ringtones on the 3GS phone, the format has to be in .m4r format.
Ah! Now we're getting somewhere.
For some strange reason, Apple removed the facility to create a ringtone in iTunes 10. But if you had bothered to Google "how to create a ringtone in iTunes?" as I did, you would have found this; http://www.simonblog.com/2010/09/06/how-to-create-ringtone-for-iphone-on-itunes- 10/ How to create a ringtone for iPhone on iTunes 10, which has step-by-step instructions for you.
Can I suggest for the future that you concentrate on what you want to do, instead of moaning about on what you think iTunes cannot do?
I notice - for example - that a crucial step in the process is to create an AAC version when creating the ringtone. (You then use the file manager on your computer to change the AAC "m4a" file extension to "m4r" which is a ringtone. This step is in the procedure I linked to.) But in your haste to fire off your missive, you carry on about iTunes not being able to convert to formats you do not actually want to use, while the very format you do need is already selected.