... Is to remove everything right down to the studs and go from there. You can install Greenboard or concrete backerboard depending on how you're finishing the walls. Greenboard is NOT waterproof! So if you're installing tile over it, be sure it's properly sealed. If you're using backerboard, get a good carbide-tipped knife.
My best to ya and hope this helps.
PS: If you use backerboard, and it isn't sitting flush up against the studs, use furring strips where gaps occur between the stud and the backerboard.