Microsoft Knowledge Base Article 308164 contains the following summary:
This article describes how to create and configure Web applications in Internet Information Services (IIS) 5.0.
An IIS application is any file that is executed in a defined set of directories in your Web site. When you create an application, you designate the starting-point directory (also known as the "application root") in your Web site. Each file or folder within the starting-point directory is considered as part of that application until another starting-point directory is created. You use directory boundaries to define the scope of a Web application.
In IIS 5.0, an application starting point is indicated by a "package" icon if it is created for a virtual directory or physical directory. If it is created for a Web site, the starting point is indicated by a "globe in a hand" icon.