First, I would highly suggest using another type of material, such as hardibacker or durarock rather then just drywall. Both items I have listed will not absorb and hold water as drywall will. These items are both highly water resistent and will help to resist the growth of mold. Secondly, you absolutely want to cover the flange. This is a debable topic of what method works best. Furring the studs or cutting into the studs below the height of the tub to reduce their thicknest are both acceptable methods in my opinion. However I try to save the integrity of the studs anytime given the chance. My preferred method is adding a 1.5" wide x 1/4" thick piece of osb or plywood onto the studs from ceiling down to the top of the tub flange before screwing my hardibacker board up. This often leaves a small gap behind the actual flange and the backerboard, which i fill with a silicone in order to stop water from finding its way upward. I'm sure some other members may chime in with their acceptable methods.