1. Absolutely you should install the planking in the flat. It will be much easier to install and trim the edges that way. I completely finished my wall interiors before erecting them, and it worked out really well. One thing you may need to factor in, though, is as the weight of the wall goes up, you may need help maneuvering them. (Mine having minimum framing and no outside skin, only weighed 45 lbs with the door... but w/o the window unit).
2. The wood fibers are strong along their long axis, but weaker at the joins between fibers. Since they are long and stringing in the direction of growth they resist bending in that direction, so we all usually bend our plywood with the direction of the outer plies. Paint alone does not do a good job of binding the wood fibers and preventing them from splitting or checking, especially the stressed fibers of bent plywood; so over a short time the wood opens up and takes the paint with it, allowing water in; the wood swells and it gets worse.
Have you considered gluing canvas or fabric over and painting that? This method is discussed at length in the foamie forum and has been used very successfully over plywood and directly over foam. It's actually an old boat building technique. The unidirectional orientation of the woven cloth fibers bound to the ply using wood glue reinforce the wood fibers in their weak direction, offering a more stable substrate for primer and paint. Worth consideration.