Drywall – Do I need to mud drywall before applying ship lap

Yes, you need to use a drywall sealer on bare drywall. Using a primer or a sealer would also help blend in the differences with the existing surface you want to cover.

http://www.ehow.com/about_6636020_drywall-sealer-vs_-primer.html

Hang everything horizontal. Throw some 1x6s (using wider board will really cover any hanging mistakes - sure 1x4s would work too) on the main seams to make a faux rail. A lot of decorators are breaking up rooms like this now. The rail usually being white and different colors on top and bottom. Your would also need something for the vertical seams. You can go with 1x6s or 4s again. This would look fine for the bottom section and could look fine for top but not common. I guess it would have a alsace/swiss feel.

On corners, including ceiling joins you can use quarter round. If you painted this well it wouldn't really be that noticeable. White for ceiling joins and the same color as surrounding paint for the other corners or seams.

This could be done. It could look great. You could even convince me if you were really good with wood work that this could be done in a similar amount of time as mudding. But you will spend more time on materials and will have a style that not everyone is thrilled with.

On the issue with taping and mudding... If you apply your coats thin enough then it isn't messy at all. I do 5 total coats. I scrape with my knife between each coat. After the 4th coat I might sand a little if I was messy - but not much. It isn't messy or hard. It is very time consuming I agree.