"Smart object" is a kind of "child" file embedded in its "parent" document.
in the Layers palette you can recognize a smart object by special 
symbol on its thumbnail.
Why use smart objects? Well, the first reason is, that they can be transformed non-destructively (more about).
And even more important reason is smart filters. Imagine, that you can apply several filters to a text and then edit its contents without starting all over again.
On the other hand, the main shortcoming of the smart objects is that you can't edit it with regular tools. For instance, if you try to paint over a smart object with the Brush, PSE suggests "simplifying" layer.
You can find all the E+ functions for creating and handling smart objects in the Commands panel of the "Layers" dialog (screenshot).
