I don't know exactly what they did, but I can tell you they didn't "just squish the graphics" for arcade mode.
I hate to break it to ya, but... they just squished the graphics.
The reason it plays better like that is because it's closer to the original arcade aspect ratio. Let's say, for example in the arcade, your code told the dragon to move up by 1 pixel per gametick if you held UP and left by one pixel per gametick if you held LEFT. That's going to feel totally different on the PCE when it's stretched about +20% horizontally. It feels like you move sideways very slowly, but up and down at normal speed. I ran into this when tom and i hacked Super Raiden. That's why he added the arcade aspect mode to it.