A. Only you can find out why this title is important to your friend, so ask her. And only you can decide if going along with it is okay. If your friend insists on being called "aunt," the friendship may not be worth losing over an occasional wince when you hear your daughter call her that.
If you're concerned that your child might get confused about who's a real aunt and who's not, you might explain, "Sandy isn't your real aunt but we call her that because we love her like she's family and she adores it when you call her auntie."
If you feel you must nip this in the bud, then suggest to your friend that she be given her own special title. I'm not quite sure what it would be (Honorary Aunt Sandy doesn't exactly roll off the tongue), but your child might be the best person to come up with it. I'd be willing to bet that whatever pet name she invents will be sweet and meaningful to your friend, even if it's just Sandy Pandy.