Yes, it does take the analog signal, converts it to digital, then uses the digital bass management, and then finally converts it back to analog.

The best way to determine if there is degradation or not is to experiment with the switch. On my 990, I don't believe that there is any meaningful degradation (the 990 uses this digital approach for the 7.1 direct input unless all speakers are set to large). I'd suggest trying it in the "HPF/LPF" position first to see if the 80Hz crossover sounds any different from the A/D/A approach. If your player actually has bass management that is more robust than "large/small" speaker settings, you might also try "Bypass" and play with those settings, but if the only option is large or small the player is likely using an 80Hz crossover as well.