Challah, Chapter 2, Mishnah 5. As we have mentioned, the obligation to separate challah begins from the moment the dough is kneaded, from the moment the flour and water are worked together. Our Mishnah addresses the question: what is the status of someone who separates challah before that time?
"HaMafrish challaso kemach - einah challah, ve'gezel be'yad kohen":
If a person separates challah while the grain is still flour, before he has added water and kneaded the dough, his separation is no separation at all, and the flour does not become challah. Such an early separation accomplishes nothing. Moreover, if he gave it to a kohen and the kohen took it for himself claiming that it is challah, it is stolen property in his hands, since this is not challah and he has no right to hold on to it as challah.
What, then, is the status of the dough and of the flour that was set aside?
"Ha'isah atzmah chayeves be'challah" - the dough from which that flour was taken, which was then kneaded, remains subject to the obligation, and challah must be separated from it in the proper way, since the separation made while it was still flour is of no effect.
"Ve'hakemach, im yesh bo ke'shiur, chayav be'challah" - this refers to the flour that was set aside as challah. If the batch was large, so that even the flour that was taken from it contains the measure that obligates challah, five quarters of a kav of flour, then it is obligated in challah in its own right, and challah must be separated from it because of its own obligation.
"Ve'asur le'zarim - divrei Rabbi Yehoshua":
Even though this separation is invalid and has no force, a person who is not a kohen may not eat this flour. The reason: after all, a person took this flour and called it challah, and if people see a non-kohen eating it, they will assume it is genuine challah and will come to say that challah may be eaten by non-kohanim, which is not so. Therefore, although the separation is invalid, the Sages ruled that it may not be eaten by one who is not a kohen. This is the opinion of Rabbi Yehoshua.
The Sages' challenge and Rabbi Yehoshua's answer:
"Amru lo: maaseh, ve'kafshah zaken ve'zar" - the Sages answered him from an incident that actually occurred: such challah was snatched up and taken by an elderly Torah scholar who was a non-kohen, in order to eat it. This incident would seem to prove the opposite of your position, Rabbi Yehoshua: it is permitted for a non-kohen to eat, since it has no status of challah at all, and the Sages never decreed that a non-kohen may not eat it.
Rabbi Yehoshua answered them: "Af hu kilkel le'atzmo ve'tiken la'acherim" - that elder erred and acted improperly, and he ruined things for himself. Even so, in a certain sense he improved matters for others: since he acted this way, others are liable to rely on him, and their guilt will be lessened by the claim that they relied on that elder who took the challah. But he himself acted improperly, and in Rabbi Yehoshua's view the rabbinic prohibition remains in force against a non-kohen eating this challah that was taken improperly.
In summary: One who separates challah from flour, before the dough is kneaded, has accomplished nothing: it is not challah, and if a kohen took it, it is stolen property in his hands. The dough remains subject to the obligation, and the flour that was set aside, if it contains the required measure, is obligated in challah in its own right. And in Rabbi Yehoshua's view, even though this is not challah, it is forbidden for non-kohanim to eat, out of concern that onlookers will be misled, and this is also how he answered the Sages when they challenged him from the incident of the elder.