Answers

The drywall that has water damage should be removed. The wood studs might also need to be replaced depending on if there is mold or rot. The insulation behind the drywall should also be replaced. The base molding might also need replacing as well as the flooring.  

Per ANSI/IICRC S500 Standards and Reference Guide.

"Restorers should consider drywall restoation when it can e verified that no structural integrity has been lost.  Dywall can be restoragle if the water is Category 1 or 2, there is no obvious swelling, seams are intact, and there is no idication of fungal growth.  Drywall should be replaced when contaminated with Category 3 water, damage is obvious (e.g., swelling, seam sagging, seperation), fungal growth is present on paper coverings on either side, or when blown-in insulation materials behind the drywall have likely packed down."